Financial Management DCOM307/DMGT405/DCOM406

Transcription

1 Financial Management DCOM307/DMGT405/DCOM406

2 FINANCIAL MANAGEMENT

3 Copyright 2012 P K Sinha All rights reserved Produced & Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi for Lovely Professional University Phagwara

4 SYLLABUS Financial Management Objectives: To make the students aware regarding the basic concepts of financial management i.e capital budgeting, cost of capital, sources of finance, capital structure etc. Sr. No. DMGT405 FINANCIAL MANAGEMENT Description 1. Financial Management: Meaning, Objective and scope, Finance functions Investment, financing and dividend decisions, Financial goal- Profit Maximization vs. Wealth Maximization 2. Concept of time value of money: Present & future value of annuities & Single Amount, perpetuity, Growth rate calculations 3. Source of Finance: Short term and long term Source of Finance, Leasing as a Source of Finance 4. Concept of economic value added 5. Risk and return analysis: Risk Measurement 6. Cost of Capital: Concept and its significance, Measurement of cost of capital of various source of funds, Weighted average cost of capital 7. Capital structure decision: theories of Capital Structure, Optimum Capital Structure Leverage: Operating and Financial Leverage 8. Capital budgeting: Meaning and Process, Methods of analyze capital budgeting decisions, Capital rationing, Capital decision under risk and uncertainty 9. Working Capital: Concept and significance, Determining working capital requirements, Management of Inventory, debtors and cash, Financing of working capital needs 10. Management of surplus: Retained earning and dividend policy, Theories of dividend, Forms of dividend and corporate dividend behavior. DCOM406 FINANCIAL MANAGEMENT Sr. No. Description 1. Financial management: meaning, scope and objectives Financial decision making and planning: objectives types and steps in financial planning; Investment, financing and dividend decisions 2. Time value of money: compounding and discounting techniques. 3. Capital Budgeting: methods, capital rationing, risk and uncertainty in capital budgeting decisions 4. Sources of finance: short-term and long-term, leasing as a source of finance 5. Capital structure decisions: theories of capital structure, optimum capital structure 6. Cost of capital: Significance and computation of cost of capital equity, preference, debt and retained earnings, weighted average cost of capital 7. Leverage: operating, financial and combined. 8. Working capital: concept, significance and determinants, sources of working capital, Inventory Management. 9. Cash and receivable management, 10. Dividend Policy: theories and forms of dividend, controversy over supremacy between dividend and retention.

5 DCOM307 FINANCIAL MANAGEMENT Sr. No. Description 1 Financial Management: meaning, scope and objectives, Financial decision making and planning: objectives types and steps in financial planning; Investment, financing and dividend decisions 2 Time Value of money 3 Sources of finance: short-term and long-term 4 Cost of Capital: Significance, computation of cost of capital equity, preference, debt and retained earnings, weighted average cost of capital. 5 Capital Budgeting: meaning, importance, limitations & methods using excel 6 Capital Structure decisions: theories of capital structure, optimum capital structure; Leverage : operating, financial and combined. 7 Working Capital: concept, significance and determinants 8 Inventory Management 9 Receivables Management (including factoring); Management of Cash 10 Dividend Policy: theories and forms of dividend

6 CONTENTS Unit 1: Introduction to Financial Management 1 Unit 2: Time Value of Money 17 Unit 3: Sources of Finance 31 Unit 4: Concept of Economic Value Added 55 Unit 5: Risk and Return Analysis 66 Unit 6: Cost of Capital 86 Unit 7: Capital Structure Decision 121 Unit 8: Concept of Leverages 141 Unit 9: Capital Budgeting 154 Unit 10: Working Capital Management 204 Unit 11: Inventory Management 231 Unit 12: Receivables Management 255 Unit 13: Management of Cash 270 Unit 14: Management of Surplus & Dividend Policy 288

7 Unit 1: Introduction to Financial Management Unit 1: Introduction to Financial Management CONTENTS Objectives Introduction 1. 1 Meaning and Scope of Financial Management Scope of Financial Management Important Topics in Financial Management 1.2 Goals/Objectives of Financial Management Profit Maximization vs. Wealth Maximization 1.3 Finance Functions Place of Finance Function in the Organizational Structure Relation of Finance with Economics Relation to Accounting Interface with other Functions 1.4 Supplementary noteworthy Aspects related to Financial Management Methods and Tools of Financial Management Forms of Business Organization 1.5 Summary 1.6 Keywords 1.7 Review Questions 1.8 Further Readings Objectives After studying this unit, you will be able to: Recognize the meaning and scope of financial management Describe the goals and objectives of financial management Explain the different Finance functions Discuss various significant aspects related to financial management Introduction Finance can be defined as the art and science of managing money. Virtually, all individuals and organizations earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets and instruments involved in the transfer of money among individuals, business and governments Meaning and Scope of Financial Management Financial management as an academic discipline has undergone fundamental changes with regard to its scope and coverage. In the earlier years, it was treated synonymously with the LOVELY PROFESSIONAL UNIVERSITY 1

8 Financial Management raising of funds. In the later years, its broader scope, included in addition to the procurement of funds, efficient use of resources Scope of Financial Management Financial Management is broadly concerned with the acquisition and use of funds by a business firm. The important tasks of financial management, as related to the above, may be categorized as follows: Financial Analysis, Planning and Control Analysis of financial condition and preference Profit planning Financial forecasting Financial control Important Topics in Financial Management Balance Sheet and Topics in Financial Management 2 LOVELY PROFESSIONAL UNIVERSITY

9 Unit 1: Introduction to Financial Management Income Statement and Topics in Financial Management Self Assessment Fill in the blanks: 1. In the earlier years, financial manageemnt was treated synonymously with the Financial management broader scope includes efficient use of resources in addition to the Current liabilities are associated with... financing policy profit margin is obtained by deducting cost of goods sold from net sales. 1.2 Goals/Objectives of Financial Management Profit Maximization vs. Wealth Maximization Traditional Approach Profit Maximization It has been traditionally argued that the objective of a company is to earn profit. This means that the finance manager has to make decision in a manner that the profit is maximised. Each alternative, therefore, is to be seen as to whether or not it gives maximum profit. Profit maximization objective gives rise to a number of problems as below: 1. Profit maximization concept should be considered in relation to risks involved. There is a direct relationship between risk and profit. Many risky propositions yield high profit. Higher the risk, higher is the possibility of profits. If profit maximization is the only goal, then risk factor is altogether ignored. LOVELY PROFESSIONAL UNIVERSITY 3

10 Financial Management 2. Profit maximization, as an objective does not take into account time pattern of return. Example: Proposal A may give a higher amount of profits compared to proposal B, yet if the returns begin to flow say, 10 years later, proposal B may be preferred, which may have lower overall profits but the returns flow is more early and quick. 3. Profit maximization, as an objective is too narrow. It fails to take into account the social considerations as also the obligations to various interests of workers, consumers, society as well as ethical trade practices. Further, most business leaders believe that adoption of ethical standards strengthen their competitive positions. 4. Profits do not necessarily result in cash flows available to the stockholder. Owners receive cash flow in the form of either cash dividends paid to them or proceeds from selling their shares for a higher price than paid initially. Modern Approach Wealth Maximization The alternative to profit maximization is wealth maximization. This is also known as Value Maximization or Net Present Worth Maximization. Value is represented by the market price of the company s equity shares. Prices in the share market at a given point of time, are the result of many factors like general economic outlook, particularly if the companies are under consideration, technical factors and even mass psychology. However, taken on a long-term basis, the share market prices of a company s shares do reflect the value, which the various parties put on a company. Normally, the value is a function of two factors: 1. The likely rate of earnings per share (EPS) of a company and 2. The capitalization rate EPS are calculated by dividing the periods total earnings available for the firm s common shares by the number of shares of common shares outstanding. The likely rate of earnings per share (EPS) depends on the assessment as to how profitably a company is going to operate in the future.! Caution The capitalisation rate reflects the liking of the investors for a company. If the company earns a higher rate of earning per share through risky operations or risky financing pattern, the investors will not look upon its shares with favour. To that extent, the market value of the shares of such a company will be low. If a company invests its fund in risky ventures, the investors will put in their money if they get higher return as compared to that from a low risk share. The market value of a firm is a function of the earning per share and the capitalisation rate. Example: Suppose the earning per share is expected to be 7 for a share, and the capitalisation rate expected by the shareholder is 20 per cent, the market value of the share is likely to be % This is so because at this price, the investors have an earning of 20%, something they expect from a company with this degree of risk. 4 LOVELY PROFESSIONAL UNIVERSITY

11 Unit 1: Introduction to Financial Management The important issues relating to maximizing share prices are Economic Value Added (EVA) and the focus on stakeholders. Economic Value Added (EVA) is a popular measure used by many firms to determine whether an investment proposed or existing contribute positively to the owner s wealth. EVA is calculated by subtracting, the cost of funds used to finance or investment from its after-tax-operations profits. Investments with positive EVA increase shareholder value as those with negative EVA reduce shareholders value. Example: The EVA of an investment with after tax operations profits of 510,000 and associated financing costs of 475,000 would be 35,000 (i.e. 410, ,000). Because this EVA is positive, the investment is expected to increase owner s wealth and is, therefore, acceptable. What about Stakeholders? Stakeholders are groups such as employees, customers, suppliers, creditors, owners and others who have a direct economic link to the firm. A firm with a stakeholder focus, consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well being but to preserve it. It is expected to provide long-run benefit to shareholders by maintaining positive stakeholder relationships. Such relationship should minimize stakeholder turnover, conflicts and litigation. Clearly, the firm can better achieve its goal of shareholder wealth maximization by maintaining cooperation with other stakeholders rather than having conflict with them. Did u know? Besides the above basic objectives, the following are the other objectives of financial management: 1. Building up reserves for growth and expansion. 2. Ensuring maximum operational efficiency by efficient and effective utilization of finance. 3. Ensuring financial discipline in the management. The Role of Ethics Ethics is standards of conduct or moral judgment. Today, the business community in general and the financial community in particular are developing and enforcing ethical standards, purpose being to motivate business and market participants to adhere to both the letter and the spirit of laws and regulations concerned with business and professional practice. An effective ethics programme is believed to enhance corporate value. An ethics programme can reduce potential litigation and judgment costs, maintain a positive corporate image, and build shareholders confidence, and gain the loyalty, commitment and respect of the firms stakeholders. Such actions, by maintaining and enhancing cash flow and reducing perceived risk, can positively affect the firm s share prices. Ethical behaviour is, therefore, viewed as necessary for achieving the firm s goal of owner wealth maximization. LOVELY PROFESSIONAL UNIVERSITY 5

12 Financial Management Self Assessment Fill in the blanks: 5. There is a..relationship between risk and profit. 6. is also known as Value maximization or Net Present Worth maximization. 7. A firm with a stakeholder focus, consciously avoids actions that would prove to stakeholders. 8. Ethics programme reduces potential litigation and..costs and gain the loyalty, commitment and respect of the firms stakeholders. 1.3 Finance Functions Financial Management is indeed, the key to successful business operations. Without proper administration and effective utilization of finance, no business enterprise can utilize its potentials for growth and expansion. Financial management is concerned with the acquisition, financing and management of assets with some overall goals in mind. In the contents of modern approach, the discussions on financial management can be divided into three major decisions viz., (1) Investing; (2) Financing; and (3) Dividend decision. A firm takes these decisions simultaneously and continuously in the normal course of its business. Firm may not take these decisions in a sequence, but decisions have to be taken with the objective of maximizing shareholders wealth. Investing 1. Management of current assets (cash, marketable securities, receivables and inventories) 2. Capital budgeting (identification, selection and implementation of capital projects) 3. Managing of mergers, reorganizations and divestments Financing 1. Identification of sources of finance and determination of financing mix 2. Cultivating sources of funds and raising funds Dividend Decision This is the third financial decision, which relates to dividend policy. Dividend is a part of profits, that are available for distribution, to equity shareholders. Payment of dividends should be analyzed in relation to the financial decision of a firm. There are two options available in dealing with the net profits of a firm, viz., distribution of profits as dividends to the ordinary shareholders where, there is no need of retention of earnings or they can be retained in the firm itself if they require, for financing of any business activity. But distribution of dividends or retaining should be determined in terms of its impact on the shareholders wealth. The Financial manager should determine optimum dividend policy, which maximizes market value of the share thereby market value of the firm. Considering the factors to be considered while determining dividends is another aspect of dividend policy. 6 LOVELY PROFESSIONAL UNIVERSITY

13 Unit 1: Introduction to Financial Management Place of Finance Function in the Organizational Structure The finance function is almost the same in most enterprises. The details may differ but the important features are universal in nature. The finance function occupies such a major place that it cannot be the sole responsibility of the executive. The important aspects of the finance function have to be carried on by the top management i.e., the Managing Director and the Board of Directors. It is the Board of Directors, which makes all the material final decisions involving finance. Financial management in many ways is an integral part of the jobs of managers who are involved in planning, allocation of resources and control. The responsibilities for financial management are disposed throughout the organization. Example: 1. The engineer, who proposes a new plant, shapes the investment policy of the firm. 2. The marketing analyst provides inputs in the process of forecasting and planning. 3. The purchase manager influences the level of investment in inventories. 4. The sales manager has a say in the determination of receivable policy. 5. Departmental managers, in general, are important links in the financial control system of the firm. The Chief Financial Officer (CFO) is basically to assist the top management. He has an important role to contribute to good decision-making on issues that involve all the functional areas of the business. He must clearly bring out financial implications of all decisions and make them understood. CFO (his designation varies from company to company) works directly under the President or the Managing Director of the company. Besides routine work, he keeps the Board of Directors informed about all the phases of business activity, including economic, social and political developments affecting the business behaviour. He also furnishes information about the financial status of the company by reviewing from time-to-time. The CFO may have different officers under him to carry out his functions. Broadly, the functions are divided into two parts. 1. Treasury function 2. Control function Treasury function (headed by financial manager) is commonly responsible for handling financial activities, such as financial planning and fund raising, making capital expenditures decisions, managing cash, managing credit activities, managing the pension fund and managing foreign exchange. The control function (headed by Chief Accountant/Financial Controller) typically handles the accounting activities such as corporate accounting, tax management, financial accounting and cost accounting. LOVELY PROFESSIONAL UNIVERSITY 7

14 Financial Management The treasurer s focus tends to be more external, the controllers focus is more internal: Figure 1.1: Organizational chart of Finance function Chief Finance Officer Treasurer Controller Cash Manager Credit Manager Financial Accounting Manager Cash Accounting Manager Capital Budgeting Manager Fund Raising Manager Tax Manager Data Processing Manager Portfolio Manager Internet Auditor Relation of Finance with Economics The field of finance is closely related to economics. Financial managers must be able to use economic theories as guidance for efficient business operation. Example: supply-demand analysis, profit-maximizing strategies, and price theory. The primary economic principle used in managerial function is marginal analysis, the principle that financial decisions should be made and actions taken only when the added benefits exceed the added costs. Nearly all financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs.! Caution Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy Relation to Accounting The firm s finance (treasurer) and accounting (controller) activities are closely related and generally overlapped. Normally, managerial finance and accounting are not often easily distinguishable. In small firms, the controller often carries out the finance function and in large firms many accountants are also involved in various finance activities. There are two basic differences between finance and accounting: 1. Emphasis on cash flows: The accountant s primary function is to develop and report data for measuring the performance of the firm, assuming its financial position and paying taxes using certain standardized and generally accepted principles. The accountant prepares financial statements based on accrual basis. The financial manager places primary emphasis on cash flows, the inflow and outflow of cash. 2. Relating to decision-making: Accountants devote most of their operation to the collection and presentation of financial data. The primary activities of the financial manager in addition to ongoing involvement in financial analysis and planning are making investment decisions and making financing decisions. Investment decisions determine both the mix and the type of assets held by the firm. Financing decisions determine both the mix and 8 LOVELY PROFESSIONAL UNIVERSITY

15 Unit 1: Introduction to Financial Management the type of financing used by the firm. However, the decisions are actually made on the basis of cash flow effects on the overall value of the firm Interface with other Functions Finance is defined as the lifeblood of an organization. It is a common thread, which binds all the organizational functions as each function when carried out creates financial implications. The interface between finance and other functions can be described as follows: Manufacturing Finance 1. Manufacturing function necessitates a large investment. Productive use of resources ensures a cost advantage for the firm. 2. Optimum investment in inventories improves profit margin. 3. Many parameters of the production cost having effect on production cost are possible to control through internal management thus improving profits. 4. Important production decisions like make or buy can be taken only after financial implications have been considered. Marketing Finance 1. Many aspects of marketing management have financial implications e.g., hold inventories to provide off the shelf service to customers and thus increase sales; extension of credit facility to customers to increase sales. 2. Marketing strategies to increase sales have additional cost impact, which needs to be weighed carefully against incremental revenue. Personnel Finance In the global competitive scenario, business firms are moving to leaner and flat organizations. Investments in Human Resource Development are also bound to increase. Restructuring of remuneration structure, voluntary retirement schemes, sweat equity etc., has become major financial decisions in the area of human resource management. Task Which of the following functions should be the responsibility of a finance manager? 1. Maintaining the books of account. 2. Negotiating loans with banks. 3. Conducting of internal audit. 4. Deciding about change in the policies regarding recruitment. 5. Change in marketing and advertising techniques routine. Strategic Planning Finance Finance function is an important tool in the hands of management for strategic planning and control on two counts: 1. The decision variables when converted into monetary terms are easier to grasp. 2. Finance function has strong inter-linkages with other functions. Controlling other functions through finance route is possible. LOVELY PROFESSIONAL UNIVERSITY 9

16 Financial Management Self Assessment Fill in the blanks: 9. Financial management can be divided into three major decisions which are investing; Financing; and decision. 10. Identification of sources of finance and determination of financing mix is a part of decision. 11. Finance is defined as the of an organization. 12. decisions determine both the mix and the type of assets held by the firm. 1.4 Supplementary noteworthy Aspects related to Financial Management Modern financial management has come a long way from the traditional corporate finance. The finance manager is working in a challenging environment, which changes continuously. As the economy is opening up and global resources are being tapped, the opportunities available to finance manager have no limits. At the same time one must understand the risk in the decisions. Financial management is passing through an era of experimentation and excitement, as a large part of the finance activities carried out today were not heard of a few years ago. A few instances are enumerated below: 1. Interest rates have been deregulated. Further, interest rates are fluctuating, and minimum cost of capital necessitates anticipating interest rate movements. 2. The rupee has become freely convertible in current account. 3. Optimum debt equity mix is possible. Firms have to take advantage of the financial leverage to increase the shareholders wealth. However, financial leverage entails financial risk. Hence a correct trade off between risk and improved rate of return to shareholders is a challenging task. 4. With free pricing of issues, the optimum price of new issue is a challenging task, as overpricing results in under subscription and loss of investor confidence, whereas underpricing leads to unwarranted increase in a number of shares and also reduction of earnings per share. 5. Maintaining share prices is crucial. In the liberalized scenario, the capital markets are the important avenue of funds for business. The dividend and bonus policies framed have a direct bearing on the share prices. 6. Ensuring management control is vital, especially in the light of foreign participation in equity (which is backed by huge resources) making the firm an easy takeover target. Existing managements may lose control in the eventuality of being unable to take up the share entitlements. Financial strategies to prevent this are vital to the present management Methods and Tools of Financial Management 1. In the area of financing, funds are procured from long-term sources as well as short-term sources. Long-term funds may be made available by owners, i.e., shareholders, lenders through issue of debentures/bonds, from financial institutions, banks and public at large. Short-term funds may be procured from commercial banks, suppliers of goods, public deposits etc. The finance manager has to decide on optimum capital structure with a view 10 LOVELY PROFESSIONAL UNIVERSITY

17 Unit 1: Introduction to Financial Management to maximize shareholder s wealth. Financial leverage or trading on equity is an important method by which return to shareholders can be increased. 2. For evaluating capital expenditure (investment) decisions, a finance manager uses various methods such as average rate of return, payback, internal rate of return, net present value and profitability index. 3. In the area of working capital management, there are various methods for efficient utilization of current resources at the disposal of the firm, thus increasing profitability. The centralized method of cash management is considered a better method of managing liquid resources of the firm. 4. In the area of dividend decision, a firm is faced with the problem of declaring dividend or postponing dividend declaration, a problem of internal financing. There are tools to tackle such situation. 5. For the evaluation of a firm s performance, there are different methods. Example: Ratio analysis is a popular technique to evaluate different aspects of a firm. 6. The main concern of the finance manager is to provide adequate funds from the best possible source, at the right time and the minimum cost and to ensure that the funds so acquired are put to best possible use through various methods/techniques are used to determine that funds have been procured from the best possible available services and the funds have been used in the best possible way. Funds flow and cash flow statements and projected financial statements help a lot in this regard. Task Which of the following statements do you agree with? 1. Financial management is essential only in private sector enterprises. 2. Only capitalists have to bother about money. The bureaucrat is to administer and not to manage funds. 3. The public administrators in our country must be given a basic understanding of essentials of finance. 4. A state-owned transport company must immediately deposit in the bank all its takings. 5. Financial Management is counting pennies. We do not believe in such miserly attitude Forms of Business Organization The three most common forms of business organization are sole proprietorship, partnership and the company. Other specialized forms of business organizations also exist. Sole proprietorship is the most in terms of total receipts and in net profits the corporate form of business dominates. Sole Proprietorship A sole proprietorship is a business owned by one person who runs for his own profit. Majority of the business firms are sole proprietorships. The typical sole proprietorship is a small business LOVELY PROFESSIONAL UNIVERSITY 11

18 Financial Management Example: bakeshop, personal trainer or plumber. The majority of sole proprietorship are found in the wholesale, retail, service and construction industries. Typically, the proprietor along with a few employees runs the business. He raises capital from personal resources or by borrowing and is responsible for all business decisions. The sole proprietor has unlimited liability, towards creditors not restricted to the amount originally invested. The key strengths and weaknesses of sole proprietorship are given in Table 1.1 below. Partnership A partnership firm is a business run by two or more persons for profit. Partnership accounts for the next majority of business and they are typically larger than sole proprietorship. Finance, legal and real estate firms often have large number of partners. Most partnerships are established by a written contract known as Deed of Partnership. In partnership, all partners have unlimited liability for all the debts of the partnership. The strengths and weaknesses or partnerships are summarized in Table below. Did u know? Which is the governing act for partnership in India? In India, partnership is governed by the Partnership Act, Company Form A company form of business is a legal entity, separated from the owners, with perpetual succession. Just like an individual, the company can sue and be sued, make and be party to contracts and acquire property in its own name. The company form of organization is the dominant form of business organization in terms of receipts and profits. Although, corporations are involved in all types of business, manufacturing corporation account for the largest portion of corporate business receipts and net profits. The key strengths and weaknesses of corporate form are summarized in Table below. The owners of the company are its shareholders, whose ownership is evidenced by either common shares or preference shares. Shareholders get a return by receiving dividends i.e., periodic distribution of earnings or gains through increase in share price. The owner s liability is limited to the amount paid on their shares. Shareholder elects the Board of Directors through vote. The Board of Directors has the ultimate authority in running the organization including making the general policy. The President or Chief Executive Office (CEO) is responsible for managing day-to-day operations and carrying out the policies established by the Board. The CEO is required to report periodically to the firm s board of directors. The corporate form of business is subject to strict control by Regulatory Agencies including Companies Act, 1956, SEBI, etc. 12 LOVELY PROFESSIONAL UNIVERSITY

19 Unit 1: Introduction to Financial Management Table 1.1: Strengths and Weaknesses of the Common Forms of Business Organizations Sole Proprietorship Partnership Company Strengths Owners receive all profits and incur all losses. Can raise more funds than sole proprietorship. Owner s liability is limited to the extent paid on their shares. Low organizational costs Borrowing powers enhanced by more owners. Can achieve large size via sale of shares. Income is included and taxed on owners personal tax return. More available manpower and managerial skill. Owners hip (share) is readily transferable. Independence Income included and mixed on individual partner s tax return. Long life of the firm. Secrecy Can have professional managers. Ease of dissolution Has better access to financing. Receives some tax advantage. Owner has unlimited liability towards debt of the firm Owners have unlimited liability and may have to cover debts of other partners. Taxes generally higher, because corporate income is taxed and dividends paid to owners are also axed (the latter has been exempted at the hands of the shareholders in India). Weaknesses Limited fund raising power limits growth Partnership is dissolved when partner dies. More expensive to organize than other forms of business. Proprietor must be jack-of-all trades. Difficult to give employees long-run career opportunities. Lacks continuity when proprietor dies or unable to operate. Difficult to liquidate or transfer partnership. Subject to greater control by regulating authorities. Lacks secrecy since the shareholders must receive financial reports at periodic intervals. Self Assessment Fill in the Blanks: 13. In the area of financing, funds are procured from..sources as well as sources. 14. The three most common forms of business organization are sole proprietorship, partnership and the. 15. The.method of cash management is considered a better method of managing liquid resources of the firm. 16. The dividend and bonus policies framed have a direct bearing on the... LOVELY PROFESSIONAL UNIVERSITY 13

20 Financial Management Case Study Case: Bhatt Industries Basic Planning This case will help the reader, develop an approach to structuring a case solution. It requires a logical approach to solving a general financial problem. Bhatt Industries has been manufacturing fireworks at a small facility just outside Greensboro, North Carolina. The firm is known for the high level of quality control in its production process and is generally respected by distributors in the states, where fireworks are legalized. Its selling market is fairly well defined; it has the capacity to produce 800,000 cases annually, with peak consumption in the summer. The firm is fairly confident, that the whole of next year s production can be sold for 25 a case. On September 7, the company has 8,000,000 in cash. The firm has a policy against borrowing, to finance its production, a policy first established by William Bhatt, the owner of the firm. Mr. Bhatt keeps a tight rein on the firm s cash and invests any excess cash in treasury bonds, that pays a 12 per cent return and involve no risk of default. The firm s production cycle revolves around the seasonal nature of the fireworks business. Production begins right after Labour Day and runs through May. The firms sales occur in February through May; the firm closes from June 1 to Labour Day, when its employees return to farming. During this time, Mr. Bhatt visits his grandchildren in New York and Pennsylvania. As a result of this scheduling, the firm pays all its expenses during September and in May receives, all its revenues from its distributors within 6 weeks after the 4th of July. The customers send their checks directly to Kenmy National Bank, where the money is deposited in Bhatt s account. Mr. Bhatt is the only full-time employee of his company and he and his family hold all the common stock. Thus, the company s only costs are directly related to the production of fireworks. The costs are affected by the law of variable proportions, depending on the production level. The first 100,000 cases cost 16 each; the second 100,000 cases, 17 each; the third 100,000 cases, 18 each and the fourth 100,000 cases, 19 each ; the fifth 100,000 cases, 20 each; the sixth 100,000 cases, 21 each. As an example, the total of 200,000 cases would be 1,600,000 plus 1,700,000 or 3,300,000. BHATT INDUSTRIES INCOME STATEMENT (August 31, fiscal year just ended) Revenues from operations 50,00,000 Revenues from interest on government bonds 9,20,000 Total revenues 59,20,000 Operating expenses 40,50,000 Earnings before taxes 18,70,000 Taxes 9,48,400 Net income after taxes 9,21,600 Contd LOVELY PROFESSIONAL UNIVERSITY

21 Unit 1: Introduction to Financial Management Bhatt Industries is a corporation and pays a 30 per cent tax on income, because of the paperwork involved. Mr. Bhatt invests his excess cash on September 6 in one year treasury bonds. He does not invest for shorter periods. Questions 1. How does this level affect long-term prospects of wealth maximization? 2. What should be the level of production to maximize the profit? 1.5 Summary Financial Management is broadly concerned with the acquisition and use of funds by a business firm. It has been traditionally argued that the objective of a company is to earn profit. This means that the finance manager has to make decision in a manner that the profit is maximised. The alternative to profit maximization is wealth maximization. This is also known as Value maximization or Net Present Worth maximization. The important aspects of the finance function have to be carried on by the top management i.e., the Managing Director and the Board of Directors. Finance is defined as the lifeblood of an organization. It is a common thread, which binds all the organizational functions as each function when carried out creates financial implications. The three most common forms of business organization are sole proprietorship, partnership and the company. In the area of financing, funds are procured from long-term sources as well as short-term sources. For evaluating investment decisions, a finance manager uses various methods such as average rate of return, payback, internal rate of return, net present value and profitability index. In the area of dividend decision, a firm is faced with the problem of declaring dividend or postponing dividend declaration, a problem of internal financing. 1.6 Keywords Corporate Finance: Corporate finance is the activity concerned with planning, raising, controlling and administering of the funds used in the business. Dividend: Dividend is a part of profits that are available for distribution to shareholders. Financial Management: It is the operational activity of a business that is responsible for obtaining and effectively utilising the funds necessary for efficient operations. Financing Decision: It is related to the financing mix or capital structure or leverage and the determination of the proportion of debt and equity. Investment Decision: Investment decision is related with the selection of assets, that a firm will invert. Wealth Maximization: It is maximizing the present value of a course of action (i.e. NPV = GPC of benefits Investment). LOVELY PROFESSIONAL UNIVERSITY 15

22 Financial Management 1.7 Review Questions 1. What are the tasks of Financial Management? 2. Discuss the salient features of the traditional approach to corporation finance. 3. Discuss the distinctive features of modern approach to corporation finance. 4. What is the normative goal of Financial Management? 5. Financial Management is an integral part of the jobs of all managers. Hence, it cannot be entrusted to a staff department. Discuss. 6. Discuss some of the problems financial managers in a developing country like India have to grapple with. 7. Draw a typical organization chart highlighting the finance function of a company. 8. The profit maximization is not an operationally feasible criterion. Do you agree? Justify. 9. Finance is considered to be the blood of the enterprise. Justify. 10. You are the finance manager of a firm and asked to organize all the financial decisions of the firm. Elucidate the ways in which you will do it. Answers: Self Assessment 1. raising of funds 2. procurement of funds 3. working capital 4. Gross 5. direct 6. Wealth maximization 7. detrimental 8. judgment 9. Dividend 10. financing 11. lifeblood 12. Investment 13. long-term, short-term 14. company 15. centralized 16. share prices 1.8 Further Readings Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2. Chandra, P., Financial Management Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p LOVELY PROFESSIONAL UNIVERSITY

23 Unit 2: Time Value of Money Unit 2: Time Value of Money CONTENTS Objectives Introduction 2.1 Future Value of Single Amount 2.2 Present Value of Single Amount 2.3 Present and Future Value of Annuities Future Value of Annuity of Present Value of Annuity of Perpetuities 2.5 Calculation of the Compound Growth Rate 2.6 Summary 2.7 Keywords 2.8 Review Questions 2.9 Further Readings Objectives After studying this unit, you will be able to: Explain the time value of money of single amount Identify the conception of present and future value of annuity Describe the concept of perpetuity Discuss various significant aspects related growth rate calculations Introduction This unit is concerned with interest rates and their effects on the value of money. Interest rates have widespread influence over decisions made by businesses and by us in personal lives. Corporations pay lakhs of rupees in interest each year for the use of money they have borrowed. We earn money on sums we have invested in savings accounts, certificate of deposit, and money market funds. We also pay for the use of money that we have borrowed for school loans, mortgages, or credit card purchases. We will first examine the nature of interest and its computation. Then, we will discuss several investment solutions and computations related to each. 2.1 Future Value of Single Amount Money available at present is more valuable than money value in future. Did u know? What is interest? The compensation for waiting is the time value of money is called interest. Interest is a fee that is paid for having the use of money. LOVELY PROFESSIONAL UNIVERSITY 17

24 Financial Management Example: Interest on mortgages for having the use of bank s money. Similarly, the bank pays us interest on money invested in savings accounts or certificates of deposit because it has temporary access to our money. The amount of money that is lent or invested is called principal. Interest is usually paid in proportion and the period of time over which the money is used. The interest rate is typically stated as a percentage of the principal per period of time, Example: 18 per cent per year or 1.5 per cent per month. Interest that is paid solely on the amount of the principal is called simple interest. Simple interest is usually associated with loans or investments that are short-term in nature. The computation of simple interest is based on the following formula: Simple interest = principal interest rate per time period number of time period Example:A person lends 10,000 to a corporation by purchasing a bond from the corporation. Simple interest is computed quarterly at the rate of 3 per cent per quarter, and a cheque for the interest is mailed each quarter to all bondholders. The bonds expire at the end of 5 years and the final cheque includes the original principal plus interest earned during the last quarter. Compute the interest earned each quarter and the total interest which will be earned over the 5-year life of the bonds. Solution: In this problem, principal = 10,000, interest = 3 per cent per quarter and the period of loan is 5 years. Since the time period for interest is a quarter of a year, we must consider 5 years as 20 quarters. And since we are interested in the amount of interest earned over one quarter, the period is 1 quarter. Therefore, quarterly interest equals 10, = 300 To compute total interest over the 5-year period, we multiply the per-quarter interest of 300 by the number of quarters 20, to obtain Total interest = = 6,000 Compound Interest: Compound Interest occurs when interest earned during the previous period itself earns interest in the next and subsequent periods. If 1000 is placed into savings account paying 6% interest per year, interest accumulates as follows: Principal invested in the first year Interest for first year ( ) Amount available at end of first year Interest for second year ( ) Amount available at end of second year The interest earned in the second year is greater than 60 because it is earned on the principal plus the first year s interest. If the savings account pays 6% interest compounded quarterly, 1.5% interest is added to the account each quarter, as follows: Principal invested in the first year Interest for first quarter ( /4) Amount available at end of first quarter LOVELY PROFESSIONAL UNIVERSITY

25 Unit 2: Time Value of Money Interest for second quarter ( /4) Amount available at end of second quarter Interest for third quarter ( /4) Amount available at end of third quarter Interest for fourth quarter ( /4) Amount available at end of first year With quarterly compounding, the initial investment of 1000 earned 1.37 more interest in the first year than with annual compounding. Compound interest is defined with the following terms: Future Value of 1 P = principal sum earns i = interest rate per period n = number of period during which compounding takes place a period can be any length in time A sum of money invested today at compound interest accumulates to a larger sum called the amount or future value. The future value of 1000 invested at 6% compounded annually for 2 years is The future value includes the original principal and the accumulated interest. The future value varies with the interest rate, the compounding frequency and the number of periods. If the future value of 1 principal investment is known, we can use it to calculate the future value of any amount invested. For example, at 8% interest per period, 1 accumulates as follows: Future value of 1 at 8% for 1 period = = Future value of 1 at 8% for 2 periods = = Future value of 1 at 8% for 3 periods = = The above can be diagrammed as follows: Interest is added to principal at the end of each period Figure 2.1 The end of each period is designated by a grey cylinder like figure. The arrows pointing to the end of each period indicate that payments are made into the investment. The general formula for the future value of 1, with n representing the number of compounding period is fv = (1 + i)n LOVELY PROFESSIONAL UNIVERSITY 19

26 Financial Management Using this formula, future values can be calculated for any interest rate and any number of time periods. To obtain the future value of any principal other than 1, we multiply the principal by the factor for the future value of 1. fv = (1 + i)n or fv = Pf where f is the factor in the future value of 1, with interest rate i and number of periods n. Example: XYZ Company invests 40,00,000 in certificates of deposit that earn 16% interest per year, compounded semi-annually. What will be the future value of this investment at the end of 5 years when the company plans to use it to build a new plant? Solution: Compounding is semi-annual and there are 5 years, so the number of half-year periods is 10. The semi-annual interest rate is half of the 16% annual rate or 8%. With i = 8% and n = 10, the factor in the table is Multiplying this factor by the principal investment, we get: fv = P f (n = 10, i = 8%) = 40,00, = 86,35,680 Self Assessment Fill in the blanks: 1. The compensation for waiting is the time value of money, called.. 2. The future value includes the original principal and the.. 3. The future value varies with the interest rate, the.frequency and the number of periods. 2.2 Present Value of Single Amount If 1 can be invested at 8% today to become 1.08 in the future, then 1 is the present value of the future amount of The present value of future receipts of money is important in business decision-making. It is necessary to decide how much future receipts are worth today in order to determine whether an investment should be made or how much should be invested. Finding the present value of future receipts involves discounting the future value to the present. Discounting is the opposite of compounding. It involves finding the present value of some future amount of money that is assumed to include interest accumulations. Present Value of 1 Knowing the present value of 1 is useful because it enables us to find the present value of any future payment. Assuming 8% interest per period, a table of present values of 1 can be constructed as follows: Present value of 1 discounted for 1 period at 8% = 1.0/1.08 = Present value of 1 discounted for 2 periods at 8% = /1.08 = Present value of 1 discounted for 3 periods at 8% = /1.08 = LOVELY PROFESSIONAL UNIVERSITY

27 Unit 2: Time Value of Money The general formula for the present value of 1 is pv = 1/(1+i)n The present value on the tables can be constructed from this formula.! Caution To find out the present value of any future amount, the appropriate factor from the table is multiplied by the amount. Example: Alpha company can invest at 16 per cent compounded annually. Beta company can invest at 16 per cent compounded semi-annually. Each company will need 2,00,000 four years from now. How much must each invest today? Solution: With annual compounding n=4 and I =16 per cent. With semi-annual compounding n=8 and i=8 per cent. Using the above formula we find the present value = 1/(1.16) 4 = ,00,000 = 110,458 For Beta Company present value = 2,00,000 1/(1.08)4 = 200, = 108,054 Beta company needs to invest less than Alpha Company because its investment grows faster due to more frequent compounding. Did u know? The more frequent the compounding the smaller the present value. Self Assessment Fill in the blanks: 4. Discounting is the opposite of 5. Finding the present value of future receipts involves the future value to the present. 6. The more frequent the compounding the..the present value. 2.3 Present and Future Value of Annuities An annuity is a series of equal payments made at equal time intervals, with compounding or discounting taking place at the time of each payment. Each annuity payment is called a rent. There are several types of annuities, out of which in an ordinary annuity each rent is paid or received at the end of each period. There are as many rents as there are periods. Installment purchases, long-term bonds, pension plans, and capital budgeting all involve annuities. LOVELY PROFESSIONAL UNIVERSITY 21

28 Financial Management Future Value of Annuity of 1 If you open a savings account that compounds interest each month, and at the end of each month you deposit 100 in the savings account, your deposits are the rents of an annuity. After 1 year, you will have 12 deposits of 100 each, and a total of 1200, but the account will have more than 1200 in it because each deposit earns interest. If the interest rate is 6 per cent a year, compounded monthly, your balance is The future value of an annuity or amount of annuity is the sum accumulated in the future from all the rents paid and the interest earned by the rents. The abbreviation FV is used for the future value of an annuity to differentiate it from the lower case fv used for the future value of 1. To obtain a table of future values of annuities, we assume payments of 1 each period made into a fund that earns 8 per cent interest compounded each period. The following diagram illustrates an annuity of four payments of 1, each paid at the end of each period, with interest of 8 per cent compounded each period. Figure 2.2 Notice that there are four rents and four periods, each rent is paid at the end of each period. At the end of the first period, 1 is deposited and earns interest for three periods. The next rent earns interest for two periods, and so on. The amount at the end of the fourth period can be determined by calculating the future value of each individual 1 deposit as follows: Future value of 1 at 8% for 3 periods = Future value of 1 at 8% for 2 periods = Future value of 1 at 8% for 1 period = The fourth rent of 1 earns no interest = Total for 4 rents = The formula for the future value of an annuity of 1 can be used to produce tables for a variety of periods and interest rates n (1 + 1) - 1 Fv = i Example: In the beginning of 2006, the directors of Molloy Corporation decided that plant facilities will have to be expanded in a few years. The company plans to invest: 50,000 every year, starting on June 30, 2006, into a trust fund that earns 11 per cent interest compounded annually. How much money will be in the fund on June 30, 2010, after the last deposit has been made? Solution: The first deposit is made at the end of the first 1-year period, and there is a total of 5 periods. The last deposit, made on June 30, 2010 earns no interest.the investment is an ordinary annuity with n =5 and i =11 per cent. From Table Future Value of Annuity 1 we find that the amount of an ordinary annuity of 1 is FV = Rent f (n =5, i =11%) = 50, = 311, LOVELY PROFESSIONAL UNIVERSITY

29 Unit 2: Time Value of Money If the company needs a total of 3,00,000 on June 30, 2010, how much would it have to deposit every year? Here we have to solve for the rent, given the future value, as follows: FV = Rent f (n =5, i =11%) 3,00,000 = Rent Rent = 3,00,000/ = 48, The company has to deposit 48,171 each time in order to accumulate the necessary 3,00,0000 by June 30, Present Value of Annuity of 1 The present value of an annuity is the sum that must be invested today at compound interest in order to obtain periodic rents over some future time. Notice that we use the abbreviation PV for the present value of an annuity, as differentiated from the lower case pv for the present value of 1. By using the present value of 1, we can obtain a table for the present value of an ordinary annuity of 1. The present value of an ordinary annuity of 1 can be illustrated as follows: Figure 2.3 With each rent available at the end of each period, when compounding takes place, the number of rents is the same as the number of periods. By discounting each future event to the present, we find the present value of the entire annuity. Present value of 1 discounted for 1 period at 8% = Present value of 1 discounted for 2 periods at 8% = Present value of 1 discounted for 3 periods at 8% = Present value of 1 discounted for 4 periods at 8% = Present value of annuity of 4 rents at 8% = The first rent is worth more than others because it is received earlier. Table on present value of annuities may be used to solve problems in this regard. The formula used to construct the table is: PV = (1 + i) n i Example: Mr. F, the owner of F Corporation is retiring and wants to use the money from the sale of his company to establish a retirement plan for himself. The plan is to provide an income of 5,00,000 per year for the rest of his life. An insurance company calculates that his life expectancy is 32 more years and offers an annuity that yields 9 per cent compounded annually. How much the insurance company wants now in exchange for the future annuity payments? LOVELY PROFESSIONAL UNIVERSITY 23

30 Financial Management Solution: The investment today is the present value of an annuity of 5,00,000 per year, with n =32 and i =9 per cent compounded annually. From the cumulative present value table we find the factor which is the present value if the rents were 1. Self Assessment Fill in the blanks: PV = Rent f (n =32, i =9%) = 5,00, = 52,03, is a series of equal payments made at equal time intervals, with compounding or discounting taking place at the time of each payment. 8. The.of an annuity is the sum that must be invested today at compound interest in order to obtain periodic rents over some future time. 9. The..of an annuity or amount of annuity is the sum accumulated in the future from all the rents paid and the interest earned by the rents. 2.4 Perpetuities An annuity that goes on for ever is called a perpetuity. The present value of a perpetuity of amount is given by the simple formula: C/i where i is the rate of interest. C This is because as the length of time for which the annuity is received increases, the annuity discount factor increases but as length gets very long, this increase in the annuity factor slows down.! Caution as annuity life becomes infinitely long the annuity discount factor approaches an upper limit. Such a limit is 1/i. Example: Mr. X wishes to find out the present value of investments which yield 500 in perpetuity, discounted at 5%. The appropriate factor can be calculated by dividing 1 by The resulting factor is 20. This is to be multiplied by the annual cash inflow of 500 to get the present value of the perpetuity i.e., 10,000. Managerial Problems Many business problems are solved by use of compound interest and present value tables. For example, B Corporation is investigating two possible investments. Project A is the purchase of a mine for 20,00,000 which will give an expected income from sale of ore of 480,000 per year for 10 years, after which the property will be sold at an estimated price of 600,000. Project B is the purchase of an office building that is leased for 15 years. The lease provides annual receipts of 4,00,000 at the end of the each of the next 4 years, and annual receipts of 4,50,000 for the remaining life of the lease. The purchase price is 20,00,000. B Corporation requires a 20 per cent return on its investments. Which investment is preferable? Solution: To evaluate Project A we need to find the present value of the future income stream of 4,80,000 per year for 10 years plus the present value of the future sales price of 6,00,000, both discounted to the present at the company s required rate of return of 20 per cent. 24 LOVELY PROFESSIONAL UNIVERSITY

31 Unit 2: Time Value of Money PV of annuity of 4,80,000 ( n =10, i =20%) = 480, ,12,386 PV of 6,00,000 at the end of 10 years = 600, ,906 Total present value of Project A cash inflows 21,09,292 The problem can be broken down into two separate annuities, one with receipts of 4,50,000 per year for 15 years and the other with payments of 50,000 for 4 years. The present value of the two annuities can be found by computing the present value of 4,50,000 for 15 years at 20 per cent minus an annuity of 50,000 for 4 years at 20 per cent. PV of annuity of 4,50,000 ( n=15, i=20 per cent) = 450, ,03,961 PV of annuity of 50,000 ( n=4, i=20 per cent) = 50, (1,29,437) Total present value of project B cash inflows 19,74,524 By discounting each project at the company s required rate of return, we find the Project A cash inflows have a present value of 12,09,292 and Project B cash inflows have a present value of 19,74,524. Since the asking price of each project is 20,00,000, project B should not be accepted. The value of project A is greater than the asking price, therefore the company should acquire Project A. Task Calculate the present value of cash flows of 1. Assuming an interest rate of 7% 700 per year for ever (in perpetuity) 2. Assuming an interest rate of 10% Self Assessment Fill in the blanks: 10. An annuity that goes on for ever is called a The present value of a perpetuity of C amount is given by the simple formula: C/i where i is the Many business problems are solved by use of compound interest and.tables. 2.5 Calculation of the Compound Growth Rate Compound growth rate can be calculated with the following formula: where, gr = Vo(1 + r) n = V n gr = Growth rate in percentage. Vo = Variable for which the growth rate is needed (i.e., sales, revenue, dividend at the end of year 0 ). V n = Variable value (amount) at the end of year n. Illustration: (1 + r) n = Growth rate. From the following dividend data of a company, calculate compound rate of growth for period ( ). LOVELY PROFESSIONAL UNIVERSITY 25

32 Financial Management Year Dividend per share ( ) Solution: 21 (1 + r) 5 = 31 (1 + r) 5 = 31 / 21 = : See the compound value one rupee Table for 5 years (total years - one year) till you find the closest value to the compound factor, after finding the closest value, see first above it to get the growth rate. Task Determine the rate of growth of the following stream of dividends a person has received from a company: Year Dividend (per share) (Rs) Doubling Period Doubling period is the time required, to double the amount invested at a given rate of interest. For example, if you deposit 10,000 at 6 per cent interest, and it takes 12 years to double the amount. (see compound value for one rupee table at 6 per cent till you find the closest value to 2). Doubling period can be computed by adopting two rules, namely: 1. Rule of 72 : To get doubling period 72 is divided by interest rate. Where, Doubling period (Dp) = 72 I I = Interest rate Dp = Doubling period in years Example: If you deposit will this amount double? 500 today at 10 per cent rate of interest, in how many years Solution: Dp = 72 I = = 7.2 years (approx.) 2. Rule of 69: Rule of 72 may not give the exact doubling period, but rule of 69 gives a more accurate doubling period. The formula to calculate the doubling period is: Dp = / I 26 LOVELY PROFESSIONAL UNIVERSITY

33 Unit 2: Time Value of Money Example: Take the above problem as it is and calculate doubling period. Solution: Dp = / 10 = 7.25 years. Effective Rate of Interest in Case of Doubling Period Sometimes investors may have doubts as to what is the effective interest rate applicable, if a financial institute pays double amount at the end of a given number of years. Effective rate of interest can be defined by using the following formula. (a) In case of rule of 72 where, ERI = 72 per cent Doubling period (Dp) ERI = Effective rate of interest. Dp = Doubling period. Example: A financial institute has come with an offer to the public, where the institute pays double the amount invested in the institute by the end of 8 years. Mr. A, who is interested to make a deposit, wants to know the affective rate of interest that will be given by the institute. Calculate. Solution: ERI = 72 Dp = 72 8 years = 9 per cent (b) In case of rule of ERI = Dr Example: Take the above example: 69 ERI = years = 8.98 per cent or 9 per cent Self Assessment Fill in the blanks: 13. Compound growth rate can be calculated with the formula- 14. To get doubling period 72 is divided by rate 15...period is the time required, to double the amount invested at a given rate of interest. Case Study Case: Comparing Mortgage Alternatives T he application of the time value of money principles can help you make decisions on loan alternatives. This exercise requires you to compare three mortgage alternatives Contd... LOVELY PROFESSIONAL UNIVERSITY 27

34 Financial Management using various combinations and points. Points on a mortgage refer to a payment that is made upfront to secure the loan. A single point is a payment of one per cent of the amount of the total mortgage loan. If you were borrowing 200,000 a single point would require an upfront payment of 2,000. When you are evaluating alternative mortgages, you may be able to obtain a lower rate by making an upfront payment. This comparison will not include an after-tax comparison. When taxes are considered, the effective costs are affected by interest paid and the amortization of points on the loan. This analysis will require you to compare only beforetax costs. Zeal.com allows you to compare the effective costs on alternative mortgages. You are considering three alternatives for a 250,000 mortgage. Assume that the mortgage will start in December, The mortgage company is offering you a 6% rate on a 30-year mortgage with no points. If you pay 1.25 points, they are willing to offer you the mortgage at 5.875%. If you pay 2 points, they are willing to offer you the mortgage at 5.75%. Questions 1. What are the mortgage payments under the three alternatives? 2. Which alternative has the lowest effective cost? 3. Can you explain how the effective rate is being calculated? 2.6 Summary The compensation for waiting is the time value of money, called interest. Interest is a fee that is paid for having the use of money The future value varies with the interest rate, the compounding frequency and the number of periods. The general formula for the future value of 1, with n representing the number of compounding period is fv = (1 + i)n Finding the present value of future receipts involves discounting the future value to the present. Discounting is the opposite of compounding. The general formula for the present value of 1 is pv = 1/(1+i)n An annuity is a series of equal payments made at equal time intervals, with compounding or discounting taking place at the time of each payment. Each annuity payment is called a rent. The future value of an annuity or amount of annuity is the sum accumulated in the future from all the rents paid and the interest earned by the rents. The present value of an annuity is the sum that must be invested today at compound interest in order to obtain periodic rents over some future time. An annuity that goes on for ever is called a perpetuity. The present value of a perpetuity of C amount is given by the simple formula: C/i where i is the rate of interest. Compound growth rate can be calculated with the following formula: gr = Vo(1 + r)n = Vn 28 LOVELY PROFESSIONAL UNIVERSITY

35 Unit 2: Time Value of Money 2.7 Keywords Annuity: It is a stream of equal annual cash flows. Cash Flow: It is the movement of cash into or out of a business, a project, or a financial product. It is usually measured during a specified, finite period of time Compound Interest: When interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. Compound Value: The interest earned on the initial principal becomes a part of the principal at the end of a compounding period. Interest: It is a fee paid on borrowed assets. It is the price paid for the use of borrowed money. Present Value: In case of present value concept, we estimate the present worth of a future payment/instalment or series of payment adjusted for the time value of money. Time Value of Money: Time value of money is that the value of money changes over a period of time. 2.8 Review Questions 1. Cash flows of two years in absolute terms are uncomparable Give reasons in support of your answer. 2. Define the following terms and phrases: (a) (b) (c) (d) (e) Compound sum of an annuity Present value of a future sum Present value of an annuity Annuity Discount rate 3. What happens to the effective rate of interest as the frequency of compounding is increased? 4. As a financial consultant, will you advise your client to have term deposit in a commercial bank, which pays 8% interest compounded semi-annually or 8% interest compounded annually? Why? 5. What effects do (i) increasing rate of interest and (2) increasing time periods have on the (a) present value of a future sum and (b) future value of the present sum? Why? 6. Can annuity tables be used for all types of cash flows? 7. For a given interest rate and a given number of years, is the factor for the sum of an annuity larger or smaller than the interest factor for the present value of the annuity? 8. Explain the mechanics of calculating the present value of a mixed stream that includes an annuity. 9. A limited company borrows from a commercial bank 10,00,000 at 12% rate of interest to be paid in equal end-of-year installments. What would the size of the instalment be? Assume the repayment period is 5 years. 10. If ABC company expects cash inflows from its investment proposal it has undertaken in time zero period, 2,00,000 and 1,50,000 for the first two years respectively and then expects annuity payment of 1,00,000 for next eight years, what would be the present value of cash inflows, assuming 10% rate of interest? LOVELY PROFESSIONAL UNIVERSITY 29

36 Financial Management 11. The XYZ company is establishing a sinking fund to retire 5,00,000 8% debentures 10 years from today. The company plans to put a fixed amount into the fund each year for 10 years. The first payment will be made at the end of current year. The company anticipates that the fund will earn 6% a year. What equal annual contributions must be made to accumulate 5,00,000, 10 years from now. 12. Calculate the price of 10% debentures having face value of 100, to be redeemed after 10 years at par and paying interest after every six months, assuming the market rate of interest of debentures of similar risk and maturity period is (a) 10%, (b) 12%, (c) 8% Answers: Self Assessment 1. interest 2. accumulated interest 3. compounding 4. compounding 5. discounting 6. smaller 7. Annuity 8. present value 9. future value 10. perpetuity 11. rate of interest 12. present value 13. gr = Vo(1 + r)n = Vn 14. interest 15. Doubling 2.9 Further Readings Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2. Chandra, P., Financial Management Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p LOVELY PROFESSIONAL UNIVERSITY

37 Unit 3: Sources of Finance Unit 3: Sources of Finance CONTENTS Objectives Introduction 3.1 Financial Needs and Sources of Finance of a Business 3.2 Long-term Sources of Finance Owners Capital or Equity Preference Share Capital Debentures or Bonds Types of Debentures New Financial Instruments Loans from Financial Institutions Internal Accruals 3.3 Issue of Securities Public Issue Rights Issue Private Placement Bought out Deals Euro Issues 3.4 Sources of Short-term Finance Trade Credit Bridge Finance Loans from Commercial Banks Commercial Papers (CPs) Inter-corporate Deposits (ICDs) 3.5 Venture Capital Financing 3.6 Leasing and Hire Purchase as a Source of Finance 3.7 Deferred Credit Capital Assistance Seed Government Subsidies Sales Tax Deferments and Exemptions 3.8 Summary 3.9 Keywords 3.10 Review Questions 3.11 Further Readings LOVELY PROFESSIONAL UNIVERSITY 31

38 Financial Management Objectives After studying this unit, you will be able to: Identify the different long-term sources of finance Explain the different short-term sources of finance Describe leasing as a source of finance Discuss various significant aspects related to venture capital finance Introduction One of the most important element for an entrepreneur or company implementing a new project or undertake expansion, diversification, modernization and rehabilitation scheme is working out the cost of project and the means of finance. There are several sources of finance/ funds available to any company. Among the various sources of funds available to a company an effective mechanism is required to evaluate risk, tenure and cost of each and every source of fund. The selection of the fund source is dependent on the financial strategy pursued by the company, the leverage planned by the company, the financial conditions prevalent in the economy and the risk profile of both viz., the company as well as the industry in which the company operates. Each and every source of funds has some merits and demerits. 3.1 Financial Needs and Sources of Finance of a Business Financial needs of a business: The financial needs of a business may be grouped into following three categories: 1. Long-term financial needs: Such needs generally refer to funds for a period exceeding 5 10 years. All investments in plant, machinery, land, buildings, etc., are considered as longterm financial needs. Funds required to finance permanent or hard-core working capital should also be procured from long-term sources. 2. Medium-term financial needs: Such requirements refer to funds for a period exceeding one year but not exceeding 5 years. For example, if a company as part of strategy goes for extensive publicity and advertisement campaign then such type of expenses, may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for them are classified in the category of medium term financial needs. Sometimes, long-term requirements, for which long-term funds cannot be arranged immediately, may be met from medium-term sources and thus the demand of mediumterm finance is generated. As and when the desired long-term funds are made available, medium-term loans taken earlier may be paid off. 3. Short-term financial needs: To finance current assets such as stock, debtors, cash, etc., investment in these assets is known as meeting of working capital requirements of the concern. Firms require working capital to employ fixed assets gainfully. The requirement of working capital depends upon a number of factors, which may differ from industry to industry and from company to company in the same industry. The main characteristic of short-term financial needs is that they arise for a short period of time, not exceeding the accounting period i.e., one year. The basic principle for meeting the short-term financial needs of a concern is that such needs should be met from short-term sources, and for medium-term financial needs from mediumterm sources and long-term financial needs from long-term sources. Accordingly, the method of raising funds is to be decided with reference to the period for which funds are required. Basically, there are two sources of raising funds for any business enterprise viz., owner s capital and 32 LOVELY PROFESSIONAL UNIVERSITY

39 Unit 3: Sources of Finance borrowed capital. The owner s capital is used for meeting long-term financial needs and it primarily comes from share capital and retained earnings. Borrowed capital for all the other types of requirement can be raised from different sources such as debentures, public deposits, loans from financial institutions and commercial banks, etc. The following section shows at a glance the different sources from where the three aforesaid types of finance can be raised in India. Sources of Finance of a Business 1. Long-term (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Share capital or equity share Preference shares Retained earnings Debentures/Bonds of different types Loans from financial institutions Loans from State Financial Corporation Loans from commercial banks Venture capital funding Asset securitisation International financing like Euro-issues, foreign currency loans 2. Medium-term (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Preference shares Debentures/Bonds Public deposits/fixed deposits for a duration of three years Commercial banks Financial institutions State financial corporations Lease financing/hire purchase financing External commercial borrowings Euro issues Foreign currency bonds 3. Short-term (a) (b) (c) (d) (e) Trade credit Commercial banks Fixed deposits for a period of 1 year or less Advances received from customers Various short-term provisions LOVELY PROFESSIONAL UNIVERSITY 33

40 Financial Management It is evident from the above section that funds can be raised from the same source for meeting different types of financial requirements. Financial sources of a business can also be classified as follows by using different basis: 1. According to period: (a) (b) (c) Long-term sources Medium-term sources Short-term sources 2. According to ownership: (a) (b) Owner s capital or equity capital, retained earnings, etc. Borrowed capital such as debentures, public deposits, loans, etc. 3. According to source of generation: (a) (b) Internal sources e.g., retained earnings and depreciation funds, etc. External sources e.g., debentures, loans, etc. However for the sake of convenience, the different sources of funds can also be classified into following categories: 1. Security financing financing through shares and debentures 2. Internal financing financing through retained earning, depreciation 3. Loans financing this includes both short-term and long-term loans 4. International financing 5. Other sources Self Assessment Fill in the blanks: 1. Long-term financial needs generally refer to funds for a period exceeding..years. 2. Investment in.financial assets is known as meeting of working capital requirements of the concern. 3.2 Long-term Sources of Finance There are different sources of funds available to meet long-term financial needs of the business. These sources may be broadly classified into share capital (both equity and preference) and debt (including debentures, long-term borrowings or other debt instruments). In recent times in India, many companies have raised long-term finance by offering various instruments to public like deep discount bonds, fully convertible debentures, etc. These new instruments have characteristics of both equity and debt and it is difficult to categorize these either as debt or equity. The different sources of long-term finance can now be discussed. 34 LOVELY PROFESSIONAL UNIVERSITY

41 Unit 3: Sources of Finance Owners Capital or Equity A public limited company may raise funds from promoters or from the investing public by way of owners capital or equity capital by issuing ordinary equity shares. Ordinary shareholders are owners of the company and they undertake the risks inherent in business. They elect the directors to run the company and have the optimum control over the management of the company. Since equity shares can be paid off only in the event of liquidation, this source has the least risk involved. This is more so due to the fact that equity shareholders can be paid dividends only when there are distributable profits. However, the cost of ordinary shares is usually the highest. This is due to the fact that such shareholders expect a higher rate of return on their investment as compared to other suppliers of long-term funds. Further, the dividend payable on shares is an appropriation of profits and not a charge against profits. This means that it has to be paid only out of profits after tax. Ordinary share capital also provides a security to other suppliers of funds. Thus, a company having substantial ordinary share capital may find it easier to raise further funds, in view of the fact that share capital provides a security to other suppliers of funds. Did u know? What are the governing acts for share capital? The Companies Act, 1956 and SEBI Guidelines for disclosure and investors protections and the clarifications there to lay down a number of provisions regarding the issue and management of equity shares capital. Advantages of raising funds by issue of equity shares are: 1. It is a permanent source of finance. 2. The issue of new equity shares increases flexibility of the company. 3. The company can make further issue of share capital by making a right issue. 4. There are no mandatory payments to shareholders of equity shares Preference Share Capital These are a special kind of shares, the holders of such shares enjoy priority, both as regards to the payment of a fixed amount of dividend and repayment of capital on winding up of the company. Long-term funds from preference shares can be raised through a public issue of shares. Such shares are normally cumulative i.e., the dividend payable in a year of loss gets carried over to the next year till there is an adequate profit to pay the cumulative dividends. The rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans, etc. Most of preference shares these days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period. Preference share capital is a hybrid form of financing that partakes some characteristics of equity capital and some attributes of debt capital. It is similar to equity because preference dividend, like equity dividend is not a tax-deductible payment. It resembles debt capital because the rate of preference dividend is fixed. Typically, when preference dividend is skipped it is payable in future because of the cumulative feature associated with most of preference shares. Cumulative Convertible Preference Shares (CCPS) may also be offered, under which the shares would carry a cumulative dividend of specified limit for a period of say three years, after which the shares are converted into equity shares. These shares are attractive for projects with a long gestation period. For normal preference shares, the maximum permissible rate of dividend is 14%. LOVELY PROFESSIONAL UNIVERSITY 35

42 Financial Management Preference share capital may be redeemed at a predefined future date or at an earlier stage inter alia out of the profits of the company. This enables the promoters to withdraw their capital from the company, which is now self-sufficient, and the withdrawn capital may be reinvested in other profitable ventures. It may be mentioned that irredeemable preference shares cannot be issued by any company. Preference shares have gained importance after the Finance Bill 1997 as dividends became tax exempted in the hands of the individual investor and are taxable in the hands of the company as tax is imposed on distributed profits at a flat rate. The Budget for has doubled the dividend tax from 10% to 20% besides a surcharge of 10%. The Budget for has reduced the dividend tax from 20% to 10%. Many companies raised funds during1997 through this route especially through private placement or preference shares, as the capital markets were not vibrant. The advantages of taking the preference share capital route are: 1. No dilution in EPS on enlarged capital base if equity is issued it reduces EPS, thus affecting the market perception about the company. 2. There is leveraging advantage as it bears a fixed charge. 3. There is no risk of takeover. 4. There is no dilution of managerial control. 5. Preference capital can be redeemed after a specified period Debentures or Bonds Loans can be raised from public by issuing debentures or funds by public limited companies. Debentures are normally issued in different denominations ranging from 100 to 1,000 and carry different rates of interest. By issuing debentures, a company can raise long-term loans from public. Normally, debentures are issued on the basis of a debenture trust deed, which list the terms and conditions on which the debentures are floated. Debentures are normally secured against the assets of the company. As compared with preference shares, debentures provide a more convenient mode of long-term funds. The cost of capital raised through debentures is quite low since the interest payable on debentures can be charged as an expense before tax. From the investors point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable whether or not the company makes profits. Debentures are, thus, instruments for raising long-term debt capital. Secured debentures are protected by a charge on the assets of the company. While the secured debentures of a wellestablished company may be attractive to investors, secured debentures of a new company do not normally evoke same interest in the investing public. Advantages of raising finance by issue of debentures are: 1. The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax deductible. Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment. 2. Debenture financing does not result in dilution of control. 3. In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases. 36 LOVELY PROFESSIONAL UNIVERSITY

43 Unit 3: Sources of Finance The disadvantages of debenture financing are: 1. The protective covenants associated with a debenture issue may be restrictive 2. Debenture financing enhances the financial risk associated with the firm. These days, many companies are issuing convertible debentures or bonds with a number of schemes/incentives like warrants/options etc. These bonds or debentures are exchangeable at the option of the holder for ordinary shares under specified terms and conditions. Thus, for the first few years these securities remain as debentures and later they can be converted into equity shares at a predetermined conversion price. The issue of convertible debentures has distinct advantages from the point of view of the issuing company. Firstly, such as issue enables the management to raise equity capital indirectly without diluting the equity holding, until the capital raised has started earning an added return to support the additional shares. Secondly, such securities can be issued even when the equity market is not very good. Thirdly, convertible bonds are normally unsecured and, therefore, their issuance may ordinarily not impair the borrowing capacity. These debentures/bonds are issued subject to the SEBI guidelines notified from time to time. Public issue of debentures and private placement to mutual funds now require that the issue be rated by a Credit Rating Agency Like CRISIL (Credit Rating and Information Services at India Ltd.). The credit rating is given after evaluating factors like track record of the company, profitability, debt servicing capacity, credit worthiness and perceived risk of lending.! Caution Debenture interest and capital repayment are obligatory payments Types of Debentures Debentures can be classified based on security against which it is placed and whether convertible into shares or not. Non-Convertible Debentures (NCDs) These debentures cannot be convertible into equity shares and will be redeemed at the end of the maturity period. Example:ICICI offered for public subscription for cash at par 20,00,000, 16% unsecured redeemable bonds (Debentures) of 1000 each. These bonds are fully non-convertible (i.e., the investor is not given the option of converting into equity shares); interest payable half yearly on June 30 and December 31, to be redeemed (paid back) on the expiry of 5 years from the date of allotment. But ICICI has also allowed the investors, the option of requesting the company to redeem all or part of the bonds held by them on the expiry of 3 years from the date of allotment, provided the bond holders give the prescribed notice to the company. Fully Convertible Debentures (FCDs) These debentures will be converted into equity shares either fully at one stroke or in instalments. The debentures may or may not carry interest till the date of conversion. The conversion will be at a premium either fixed before hand or as per some formula. FCDs are very attractive to the investors as their bonds are converted into equity shares at a price, which actually in the market may be much higher. LOVELY PROFESSIONAL UNIVERSITY 37

44 Financial Management Example: Let us look at the Jindal issue: The total issue was 301,72,080 secured zero interest fully convertible debentures. Of these 129,30,000 FCDs of 60 each were offered to the existing shareholders of the company as right basis in the ratio of one FCD for every one fully paid equal share held as on 30 th March of the year. The balance of 172,42,080 secured zero interest, FCD s were offered to the public at par value of 100 each. The terms of conversion were: Each fully paid FCD s will be compulsorily converted into one equity shares of 10 each at a premium of 90 per share, credited as fully paid up, at the end of 12 months from the date of investment. Partly Convertible Debentures (PCDs) These are debentures or bonds, a portion of which will be converted into equity share capital after a specified period, whereas the non-convertible part (NCD) of PCD will be redeemed as per terms of the issue after the maturity period. The non-convertible portion of the PCD will carry interest upto redemption whereas the interest on the convertible portion will be only upto the date immediately preceding the date of conversion. Normally, PCDs carry a lower rate of interest (coupon) as compared to NCDs. This is a kind of NCD with an attached warrant that gives the holder the right for allotment of equity shares through cash payment. This right has to be exercised between certain time frame after allotment, by which time the SPN will be fully paid up New Financial Instruments Non-voting shares: Useful for companies to increase net worth without losing management control. These stocks are similar in every respect to equity, the sole exception being the absence of voting rights. Detachable equity warrants: This gives the holder the right to purchase a certain number of shares (equity) at a specified price over a certain period of time (of course holders of warrants earn no income from them, till the option is exercised or warrants are sold). Warrants are often attached to debt issues as sweetener. When a firm makes a large bond issue the attachment of stock purchase warrants may add to the marketability of the issue and lower the required interest rate. A sweetener s warrants are similar to conversion features often when a new firm is raising its initial capital suppliers of debt will require warrants to permit them to participate in whatever success the firm achieves. In addition, established companies, offer warrants to debts to compensate for risk and thereby lower the interest rate/and/or provide for fewer restrictive covenants. Participating debentures: These are unsecured corporate debt securities that participate in the profits of the company. Potential issuers are existing dividend paying companies could appeal to investors willing to take risk for higher returns. Participating preference shares: Quasi equity instrument to bolster net worth without loss of management control payouts linked to equity dividend and also eligible for bonus will appeal to investors who are willing to take low risk. Convertible debentures with options: A derivative of the convertible debentures, with an embedded option, providing flexibility to the issues as well as the investor to exit from the terms of the issue. The coupon rate is specified at the time of issue. Third party convertible debenture: Debt with a warrant allowing the investor to subscribe to the equity of a third firm at a preferential price vis-à-vis the market price. Interest rate here is lower than pure debt on account of the conversion option. 38 LOVELY PROFESSIONAL UNIVERSITY

45 Unit 3: Sources of Finance Mortgage backed securities: An instrument, otherwise known as the Asset Backed Security ABS), for securitization of debt. An ABS is backed by pooled assets like mortgages, credit card receivables and the like. Convertible debentures redeemable at premium: Convertible debenture issued at face value with a put option entitling investors to sell the bond later to the issuer at a premium. It serves a similar purpose as that of convertible debt, but risks to investors are lower. Debt equity swaps: An offer from the issue of debt to convert (swap) it for common share. The risk may dilute earnings per share in the case of the issues, the expect capital appreciation may not materialize in the case of investor. Zero coupon convertible note: A Zero Coupon Convertible Note (ZCCN) converts into common shares. If investors choose to convert, they forego all accrued and unpaid interest. The risk ZCCN prices are sensitive to interest rates. Did u know? What are floating rate bonds? The bonds in which the interest rate is not fixed and is allowed to float depending upon the market conditions. This has become very popular as a money market investment Loans from Financial Institutions In India, specialized institutions provide long-term financial assistance to industry. Thus, the Industrial Finance Corporation of India, the State Financial Corporations, the Life Insurance Corporation of India, the National Small Industries Corporation Limited, the Industrial Credit and Investment Corporation, the Industrial Development Bank of India and the Industrial Reconstruction Corporation of India provide term loans to companies. Before a term loan is sanctioned, a company has to satisfy the concerned financial institution regarding the technical, commercial, economic, financial and managerial viability of the project for which the loan is required. Such loans are available at different rates of interest under different schemes of financial institutions and are to be repaid according to a stipulated repayment schedule. Term loans represent secured borrowings and at present it is the most important source of finance for new projects. They generally carry a rate of interest inclusive of interest tax, depending on the credit rating of the borrower, the perceived risk of lending and the cost of funds. These loans are generally repayable over a period of 6 to 10 years in annual, semi-annual or quarterly installments. Term loans are also provided by banks. State financial/development institutions and all-india term lending financial institutions. Banks and State Financial Corporations normally provide term loans to projects in the small scale sector, while for the medium and large industries, term loans are provided by state developmental institutions alone or in consortium with banks and State-Financial Corporations. For large scale projects all-india financial institutions provide the bulk of term finance either singly or in consortium with other all-india financial institutions, state level institutions and/or banks. After Independence, the institutional setup in India for the provision of medium and long-term credit for industry has been broadened. The assistance sanctioned and disbursed by these specialized institutions has increased impressively over the years. A number of specialized institutions have been established all over the country.! Caution The loans in many cases stipulate a number of conditions regarding the management and certain other financial policies of the company. LOVELY PROFESSIONAL UNIVERSITY 39

46 Financial Management Internal Accruals This basically means what is being ploughed back in business i.e., retained earnings and the depreciation charge. While depreciation is used for replacing an old machinery, etc., retained earnings can be used, for finding other long-term requirements of the business. The major advantage of using this as a source of long-term finance are its easy availability, elimination of issue expenses and avoiding the problem of dilution of control (with equity source of fund). The disadvantage of this source is limited funds from this source, plus foregoing of dividends receipts may lead to higher opportunity costs for the firm. Task Which of the following do you think is costliest of long-term sources of finance? Give reasons to support your answer. 1. Preference Share Capital 2. Retained Earnings 3. Equity Share Capital 4. Debentures 5. Capital raised through private placement. Self Assessment Fill in the blanks: 3. Ordinary shareholders are owners of the company and they undertake the.inherent in business. 4. Long-term funds from preference shares can be raised through a..of shares. 5. A Zero Coupon Convertible Note (ZCCN) converts into Issue of Securities A firm can raise capital from the primary market (both domestic and foreign) by using securities in the following ways: Public issue Rights issue Private placement Bought out deals Euro issues The apex body regulating the Indian securities market and the companies raising finance from it is the Securities and Exchange Board of India (SEBI). After the repeal of Capital Issues Control Act, 1947 in May 1992, SEBI was given the statutory powers to regulate the securities market Public Issue Companies issue securities in the public in the primary market and get them listed in the stock exchange. The major activities in making a public issue of securities are as below: The firm should appoint a SEBI registered category I Merchant Banker to manage the issues. The lead manager will be responsible for all the pre and post issue activities, 40 LOVELY PROFESSIONAL UNIVERSITY

47 Unit 3: Sources of Finance liaison with the other intermediaries, and statutory bodies like SEBI, Stock Exchange and the Register of Companies (ROC) and finally ensure that securities are listed on the Stock Exchange. The other intermediaries involved in the public issue of securities are underwriters, registrars, and bankers to the issues, brokers and advertising agencies. It also involves promotion of the issue, printing and dispatch of prospectus and application form, obtaining statutory clearances, filing the initial listing application, final allotment and refund activities. The cost of issue ranges between 12 15% of the issue size and may go up to 20% in adverse market conditions Rights Issue As per Section 81 of the Companies Act, 1956, when a firm issues additional equity capital it has to first offer such securities to the existing shareholders in a prorate basis. The company must give notice of maximum 14 days to each of the equity shareholders giving him the option to take the shares offered to him by the company against payment of specified money per share. The shareholder unless the articles otherwise provide, have the right to renounce the offer, in whole or in part, in favour of some others who need not be a member of the company. The cost of floating right issue is comparatively less than the public issue. Since marketing costs and other public issue expenses are avoided as the offer is made to the existing shareholders. The rights issue is also priced lower than the public issue Private Placement The private placement method involves direct selling of securities to a limited number of institutional or high net worth investors. This avoids delay involved in going public and also reduces the expenses involved in public issue. The company appoints a merchant banker to network with the institutional investor and negotiate the price of the issue. The major advantages of private placement securities are: Easy access to any company Fewer procedural formalities Access to funds is faster Lower cost involved in issues Securities can be custom-tailored for firms with special problems or opportunities Bought out Deals Bought out is a process whereby a investor or group of investors buy out a significant portion of the equity of an unlisted company with a view to sell the same to public within an agreed time frame. The company places the equity shares, to be offered to the public with a sponsor or the Merchant Banker. At the right time, the shares are off loaded to the public through the OTCE I route or by way of public issue and the funds reach the company without much delay. Further, it affords greater flexibility in terms of issue and matters relating to offloading. Major advantages of entering into a bought out deal are: Companies both existing and new, which do not satisfy conditions laid down by SEBI for premium issues, may issue at a premium through this route. The procedural complexities are reduced, and funds reach faster upfront. Added to this there is significant reduction in issue cost. An advantage accruing to the investor is that the issue price reflects the company s intrinsic value. LOVELY PROFESSIONAL UNIVERSITY 41

48 Financial Management Task A company is in dire need for funds but lost the confidence of its shareholders due to the inadequate return on investments. Which of the following methods is/are suitable to that company to raise funds? Why. 1. Public issue 2. Rights issue 3. Private placement 4. Bought out deals Euro Issues The Government of India as a part of liberalization and de-regulation of industry and to augment the financial resources of Indian companies, has allowed the companies to directly tap foreign resources for their requirements. The liberalized measures have boosted the confidence of foreign investors and also provided an opportunity to Indian companies to explore the possibility of tapping the European Market for their financial requirements. Where the resources are raised through the mechanism of EURO ISSUES i.e., Global Depository Receipts (GDRs), Foreign Currency Convertible Bonds (FCCB) and pure debt bonds. These investments are issued abroad and listed and traded as a foreign stock exchange. Once they are converted into equity, the underlying shares are listed and traded on the domestic exchange. GDRs are created when the rising company delivers ordinary shares issued in the name of overseas depository bank (depository) to the domestic custodian bank (who is an agent of the depository) against which the depository issues GDRs representing the underlying equity shares to the foreign investors. The physical possession of the shares remains with the depository and the respective foreign investors obtain GDRs from the depository evidencing their holding. The main advantage of the issue is that there is an inflow of foreign exchange through the proceeds of the issue whereas the dividend outflow is in Indian rupees. The Department of Economic Affairs, Ministry of Finance has given detailed Guidelines Regarding Issue of GD GDRs can be treated freely among non-resident investors like any other dollar-dominated security either on a foreign exchange market or in the OTC market. Foreign currency convertible bond is an equity-linked unsecured debt instrument carrying a fixed rate of interest and an option of conversion into fixed number of equity shares or GDRs of the issuer company. However, the option to retain FCCB as a bond also exists. As a bond, the issuer has the responsibility to repay the principal amount and make the specified interest payment for the given period. These bonds are listed and traded on one or more such exchanges abroad till conversion interest and well as redemption is paid in dollars or freely convertible currency. Self Assessment Fill in the blanks: 6. The private placement method involves selling of securities to a limited number of institutional or high net worth investors. 7. Foreign currency convertible bond is an equity-linked unsecured..instrument carrying a fixed rate of interest. 42 LOVELY PROFESSIONAL UNIVERSITY

49 Unit 3: Sources of Finance 3.4 Sources of Short-term Finance Trade Credit Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. Trade credit occupies very important position in short-term financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no possibility of staying back in the business. Trade credit is a spontaneous source of finance that arises in the normal business transactions of the firm without specific negotiations (automatic source of finance). In order to get this source of finance, the buyer should have acceptable and dependable credit worthiness and reputation in the market. Trade credit generally extended in the format open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. As such trade credit constitutes a very important source of finance; it represents 25 per cent to 50 per cent of the total short-term sources for financing working capital requirements. Getting trade credit may be easy to the well-established or well-reputed firm, but for a new or the firm with financial problems will generally face problem in getting trade credit. Generally suppliers look for earning record, liquidity position and payment record which is extending credit. Building confidence in suppliers is possible only when the buyer discussing his/her financial condition future plans and payment record. Trade credit involves some benefits and costs. Advantages of Trade Credit The main advantages are: 1. Easy availability when compared to other sources of finance (except financially weak companies). 2. Flexibility is another benefit, as the credit increases with the growth of the firm s sales. 3. Informality as we have already seen that it is an automatic finance. The above discussion on trade credit reveals two things. One, cost of trade credit is very high beyond the cash discount period, company should not have cash discount for prompt payment and second, if the company is not able to avail cash discount it should pay only at the end of last day of credit period, even if it can delay by one or two days, it does not affect the credit standing Bridge Finance Bridge finance refers to loans taken by a company normally from commercial banks for a short period, pending disbursement of loans sanctioned by financial institutions. Normally, it takes time for financial institutions to disburse loans to companies. However, once the loans are approved by the term lending institutions, companies, in order not to lose further time in starting their projects, arrange short-term loans from commercial banks. Bridge loans are also provided by financial institutions pending the signing of regular term loan agreement, which may be delayed due to non-compliance of conditions stipulated by the institutions while sanctioning the loan. The bridge loans are repaid/adjusted out of the term loans as and when disbursed by the concerned institutions. Bridge loans are normally secured by hypothecating movable assets, personal guarantees and demand promissory notes. Generally, the rate of interest on bridge finance is higher as compared with that on term loans. LOVELY PROFESSIONAL UNIVERSITY 43

50 Financial Management Loans from Commercial Banks The primary role of the commercial bank is to short-term requirements of industry. Of late, however, banks have started taking an interest in term financing of industries in several ways, though the formal term lending is so far small and is confined to major banks only. Term lending by banks has become a controversial issue these days. It has been argued that term loans do not satisfy the canon of liquidity, which is a major consideration in all bank operations. According to the traditional values, banks should provide loans only for short periods and for operations, which result in the automatic liquidation of such credits over short periods. On the other hand, it is contended that the traditional concept of liquidity requires to be modified. The proceeds of the term loan are generally used for what are broadly known as fixed assets or for expansion in plant capacity. Their repayment is usually scheduled over a long period of time. The liquidity of such loans is said to depend on the anticipated income of the borrowers. As a matter of fact, a working capital loan is more permanent and long-term than a term loan. The reason for making this statement is that a term loan is always repayable on a fixed date and ultimately, a day will come when the account will be totally adjusted. However, in the case of working capital finance, though it is payable on demand, yet in actual practice it is noticed that the account is never adjusted as such, and, if at all the payment is asked back, it is with a clear purpose and intention of refinance being provided at the beginning of the next year or half year. To illustrate this point let us presume that two loans are granted on January 1, 1996 (a) to A; term loan of 60, 000 for 3 years to be paid back in equal half yearly installments, and (b) to B; cashcredit limit against hypothecation, etc. of 60, 000. If we make two separate graphs for the two loans, they may be something like the figure shown below. Figure 3.1: Graphs for the Two Loans : It has been presumed that both the concerns are good. Payment of interest has been ignored. It has been presumed that cash credit limit is being enhanced gradually. The above graphs clearly indicate that at the end of 1999 the term loan would be fully settled whereas the cash credit limit might have been enhanced to over a lakh of rupees. It really amounts to providing finances for the long-term. This technique of providing long-term finance can be technically called rolled over for periods exceeding more than one year. Therefore, instead of indulging in term financing by the rolled over method, banks can and should extend credit term after proper appraisal of applications for terms loans. In fact, as stated above, the degree of liquidity in the provision for regular amortization of term loans is more than some of these so-called demand loans that are renewed from year-to-year. Actually, term financing disciplines both the banker and borrower as long- 44 LOVELY PROFESSIONAL UNIVERSITY

51 Unit 3: Sources of Finance term planning is required to ensure that cash inflow would be adequate to meet the instruments of repayments and allow an active turnover of bank loans. The adoption of the formal term loan lending by commercial banks will not in any way hamper the criteria of liquidity and as a matter of fact, it will introduce flexibility in the operations of the banking system. The real limitation to the scope of bank activities in this field is that all banks are not well equipped to make appraisal of such loan proposals. Term loan proposals involve an element of risk because of changes in the conditions affecting the borrower. The bank making such a loan, therefore, has to assess the situation to make a proper appraisal. The decision in such cases would depend on various factors affecting the conditions of the industry concerned and the earning potential the borrower Commercial Papers (CPs) Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in USA and it was an important money market instruments. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on money market. CP is a source of short-term finance to only large firms with sound financial position. Features of CP 1. The maturity period of CP ranges from 15 to 365 day (but in India it ranges between 91 to 180 days). 2. It is sold at a discount from its face value and redeemed at its face value. 3. Return on CP is the difference between par value and redeemable value. 4. It may be sold directly to investors or indirectly (through) dealers. 5. There is no developed secondary market for CP. Eligibility Criteria for Issuing CP CP is unsecured promissory note, the issue of CP is being regulated by the Reserve Bank of India. RBI has laid down the following conditions to determine the eligibility of a company that wishes to raise funds through the issue of CPs. 1. The Tangible Net worth (TNW) of the company, as per latest audited balance sheet should not be less than 4 crore. 2. The company should have been sanctioned as a fund based limit for bank(s) finance and/ or the All India Financial Institutions. 3. Company can issue CPs amounting to 75% of the permitted bank (working capital limit) credit. 4. Company s CPs receives a minimum rating of (P2 from CRISIL, A-2 form ICRA, etc.). 5. The minimum size of each CP is 5 lakhs or multiples thereof. 6. The size of any single issue should not be less than 1 crore. 7. The CP is in the form of usance promissory note negotiable by endorsement and delivery. Advantages of CP 1. It is an alternative source of finance and proves to be helpful during the period of tight bank credit. 2. It is a cheaper source of short-term finance when compared to the bank credit. LOVELY PROFESSIONAL UNIVERSITY 45

52 Financial Management Disadvantages of CP It is available only for large and financially sound companies.! Caution Commercial Paper (CP) cannot be redeemed before the maturity date Inter-corporate Deposits (ICDs) A deposit made by one firm with another firm is known as Inter-corporate Deposits (ICDs). Generally, these deposits are usually made for a period up to six months. Such deposits may be of three types: 1. Call Deposits: Deposits are expected to be payable on call. In other words, whenever its repayment is demanded on just one days notice. But, in actual practice, the lender has to wait for at least 2 or 3 days to get back the amount. Inter corporate deposits generally have 12 per cent interest per annum. 2. Three Months Deposits: These deposits are more popular among companies for investing the surplus funds. The borrower takes this type of deposits for tiding over a short-term cash inadequacy. The interest rate on these types of deposits is around 14 per cent per annum. 3. Six Months Deposits: Generally, the inter-corporate deposits are made for a maximum period of six months. These types of deposits are usually given to A category borrowers only and they carry an interest rate of around 16% per annum. Features of ICDs 1. There are no legal regulations, which make an ICD transaction very convenient. 2. Inter-corporate deposits are given and taken in secrecy. 3. Inter-corporate deposits are given based on borrower s financial sound, but in practice lender lends money based on personal contacts. Self Assessment Fill in the blanks: 8. refers to loans taken by a company normally from commercial banks for a short period, pending disbursement of loans sanctioned by financial institutions. 9. Commercial paper represents a short-term promissory note issued by firms that have a fairly high credit rating. 3.5 Venture Capital Financing The venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. In a broad sense, under venture capital financing, venture capitalists make investments to purchase equity or debt securities from inexperienced entrepreneurs, who undertake highly risky ventures with a potential of success. Methods of Venture Capital Financing The venture capital industry in India is just a decade old. The venture capitalist generally finance ventures, which are in national priority areas such as energy conservation, quality 46 LOVELY PROFESSIONAL UNIVERSITY

53 Unit 3: Sources of Finance upgradation, etc. In November 1988, the Government of India issued the first set of guidelines for venture capital companies funds and made them eligible for capital gain concessions. In 1995, certain new clauses and amendments were made in the guidelines. These guidelines require the venture capitalists to meet the requirements of different statutory bodies and this makes it difficult for them to operate as they do not have much flexibility in structuring investments. In 1999, the existing guidelines were relaxed for increasing the attractiveness of the venture schemes and induce high net worth investors to commit their funds to sunrise sectors particularly the information technology sector. Initially, the contribution to the funds available for venture capital investment in the country was from the all-india development financial institutions, state development financial institutions, commercial banks and companies in private sector. In the last couple of years, many offshore funds have been started in country and the maximum contribution is from foreign institutional investors. A few venture capital companies operate as both investment and fund management companies, while other set up funds and function as asset management companies. It is hoped that the changes in the guidelines for the implementation of venture capital schemes in the country would encourage more funds to be set up to provide the required momentum for venture capital investment in India. Some common methods of venture capital financing are as follows: 1. Equity financing: The venture capital undertakings generally require funds for a longer period but may not be able to provide returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by way of equity share capital. The equity contribution of venture capital firm does not exceed 49% of the total equity capital of venture capital undertakings so that the effective control and ownership remain with the entrepreneur. 2. Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India venture capital financiers charge royalty ranging between 2 and 15 per cent; actual rate depends on other factors of the venture such as gestation period, cash flow patterns, riskiness and other factors of the enterprise. Some venture capital financiers give a choice to the enterprise of paying a high rate of interest (which could be well above 20 per cent) instead of royalty on sales, once it becomes commercially sounds. 3. Income note: It is a hybrid security, which combines the features of both conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially low rates. IDBI s VCF provides funding equal to % of the projects cost for commercial application of indigenous technology. 4. Participating debenture: Such security carries charges in three phases in the start-up phase, no interest is charged, in next stage a low rate of interest is charged up to a particular level of operation, after that, a high rate of interest is required to be paid. Self Assessment Fill in the blanks: 10. A.loan is repayable in the form of a royalty after the venture is able to generate sales. 11..is a hybrid security, which combines the features of both conventional loan and conditional loan. LOVELY PROFESSIONAL UNIVERSITY 47

54 Financial Management 3.6 Leasing and Hire Purchase as a Source of Finance A lease is a contractual arrangement under which the owner of an asset (called the lessor) agrees to allow the case of its asset by another party (lessee) in exchange of periodic payments (lease-rental) for a specified period. The lessee pays the lease rent as a fixed payment over a period of time at the beginning or at the end of a month, quarter, half year or year. Although generally fixed, lease rents can be tailored both in terms of amount and tuning to the profits and cash flow position of the lessee. At the end of the lease contract, the asset reverts back to the real owner i.e., the lessor. However, in long-term lease contract, the lessee is generally given the option to buy or renew the lease. Lease agreements are divided into two major ones operating lease and financial lease. Operating lease is for periods shorter than the useful life of the asset and is cancelable at the option of the lessee. On the other hand, financial lease involves a relatively longer-term commitment on the part of the lessee and non-cancelable during the entire period specified in the contract. Operating lease is common among equipments/assets exposed to technological obsolescence such as computers, data processing equipments. Financial leases are commonly used for leasing land, buildings and large pieces of fixed equipments. Advantages of Leasing 1. Shifting the risk of technological obsolescence to the owner (lessor) the leasing company. 2. Easy source of finance: A lessee (user of the machine) avoids many of the restrictive covenants that are normally in the long-term loan agreements while borrowing from financial institution or commercial banks. 3. Enhance liquidity: A firm having shortage of working capital or forecasting liquidity problem may exercise the option of the selling the owned asset to a lesser (leasing company) and take it back on lease basis (the transaction is known as sale cum lease back). 4. Conserving borrowing capacity through off the balance-sheet financing. 5. Improved performance as reflected through improved turnover of assets. 6. Governance and flexibility-by adjusting the term based on losses) requirements. 7. Maintenance and specialized services: Under a full service lease, the lessee receives maintenance and other specialized services. Even in other types of lease, it is generally common to have maintenance provided by the lessor, thus absolving the lessee of the maintenance arrangement. 8. Lower administrative cuts as compared to other source of finance. Disadvantages 1. Risk of being deprived of the use of equipment of the lessors (owners) financial condition worsens, or if the leasing company is worried up, the lessee may be deprived of the use of the equipment thus disrupting normal manufacturing operations. 2. Alteration/change in the asset: Under the lease, the lessee is generally prohibited from making alterations/improvements on the leased asset without the prior approval of the lessor (the owner). 3. Terminal value of the asset: In case of assets (such as land and buildings), which have high terminal value at the end of the lease term, it would be more appropriate to own the asset than to lease it. 4. To make lease payments even if the asset has become obsolete. If a lessee leases an asset that subsequently becomes obsolete, it still must make lease payments over the remaining term of the lease. This is true even if the asset is unsaleable. 48 LOVELY PROFESSIONAL UNIVERSITY

55 Unit 3: Sources of Finance Hire Purchase Very similar to leasing is hire purchase except that in hire purchase, the ownership will be transferred to the buyer after all the hire purchase instalments are paid up. With many nonbanking finance companies offering the leasing and Chire purchase of equipments, many companies are opting for this route to finance their fixed assets. Self Assessment Fill in the blanks: 12. Lease agreements are divided into two major ones operating lease and lease lease is for periods shorter than the useful life of the asset and is cancelable at the option of the lessee. 3.7 Deferred Credit The deferred credit facility is offered by the suppliers of machinery, whereby the buyer can pay the purchase price in instalments spread over a period of time. The interest and repayment period are negotiated between the supplier and the buyer. Bill rediscounting scheme, supplier s line of credit, seed capital assistance and risk capital foundation schemes offered by financial institutions are examples of deferred credit scheme Capital Assistance Seed The seed capital assistance scheme is designed by IDBI for professionally or technically qualified entrepreneurs and/or persons possessing relevant experience, skills and entrepreneurial traits. The project cost should not exceed 2 crores and the maximum assistance under the project will be restricted to 50% of the required promoters contribution or 15 lacs whichever is lower. The seed capital assistance is interest free but carries a service charge of 1% for the first five year and 10% p.a. thereafter. However, IDBI will have the option to change interest at such rate as may be determined by IDBI based on the financial position and profitability of the company. The repayment schedule is fixed depending upon the repaying capacity of the unit with an initial moratorium up to five years. For projects with a project cost exceeding 200 lacs, seed capital may be detained from the Risk Capital and Technology Corporation Ltd. (RCTC). For small projects costing upto 5 lacs, assisted under the Natural Equity Fund of SIDBI may be availed Government Subsidies The central and state governments provide subsidies to industrial units located in backward areas. The central government has classified backward areas into three categories of districts: A, B and C. The central subsidies applicable to industrial projects in these districts are: 1. Category A Districts-25% of the fixed capital investment subject to a maximum of 25 lakh 2. Category B Districts-15% of the fixed capital investment subject to a maximum of 15 lakh LOVELY PROFESSIONAL UNIVERSITY 49

56 Financial Management 3. Category C Districts-10% of the fixed capital investment subject to a maximum of 10 lakh. State governments also offer cash subsidies to promote widespread dispersal of industries within their states. Generally, the districts notified in the state subsidy schemes are different from those covered under the central subsidy scheme. The state subsidies vary between 5% to 25% of the fixed capital investment in the project, subject to a ceiling varying between 5 lakh and 25 lakh depending on the location. Example: Satavahana Ispat Limited has been set up with the capacity to manufacture 1,20,000 tones of pig iron. The cost of project has been appraised by IDBI at 5,450 lakh and is to be mainly financed through equity capital and term loans. The unit is also eligible for a state government subsidy (Andhra Pradesh) of 20 lakh, which will also be a source of long-term finance. The unit is located at Anantapur district of Andhra Pradesh and falls into the Category of a backward area Sales Tax Deferments and Exemptions To attract industries, the state provides incentives, in the form of sales tax deferments and sales tax exemptions. Under the sales tax deferment scheme, the payment of sales tax on the sale of finished goods may be deferred for a period ranging between five to twelve years. Essentially, it implies that the project gets an interest-free loan, represented by the quantum of Sales Tax deferment period. Under the sales tax exemption scheme, some states exempt the payment of sales tax applicable on purchase of raw materials, consumables, packing and processing materials from within the state while used for manufacturing purposes. The period of exemption ranges from three to nine years depending on the state and the specific location of the project within the state. Example: Lupin Chemicals Ltd. has stated in their prospects that they are eligible for sales tax incentive for a period of five years or till they reach the ceiling of 60% of fixed capital investment whichever is earlier. Self Assessment Fill in the blanks: 14. The seed capital assistance scheme is designed by for professionally or technically qualified entrepreneurs. 15. The central and state governments provide subsidies to industrial units located in areas. Case Study Case: DLF Ltd. Lease Option D LF Ltd. is engaged in the business of leasing and hire purchase. The company also functions as a merchant banker equity researcher, corporate financier, portfolio Contd LOVELY PROFESSIONAL UNIVERSITY

57 Unit 3: Sources of Finance manager, etc. The company provides fund based as well as non-fund based financial solutions to both wholesale and retail segments. DLF Ltd. has been approached by A Ltd., Mumbai, for financial help. A Ltd. manufacturers process system for food processing, pharmaceuticals, engineering, dairy and chemical industries. A wide range of centrifugal separators, plate, spray drudgers, custom fabricated equipment for exotic metals, refrigeration compressors, are also manufactured by the company. One of the major strengths of the company is project management. A Ltd. has a well-equipped R&D centre. It has pilot plant facilities and a modern laboratory for chemical, metallurgical and mechanical analyser. The company has also set up a technology centre with advanced testing facilities. Recently, the manager of the technology centre has requisitioned for the acquisition of computerised sophisticated equipment for conducting important tests. The equipment is likely to have the useful life of three years. The cost of the equipment is 10 crore. The scrap value of the equipment at the end of its useful life will be zero for the company. The finance manager of A Ltd. has suggested that the company should take a loan for three years from a commercial bank. Repayment of the loan would be made at the end of each year in three equal instalments. The repayments would comprise of the (i) principal, and (ii) interest at 10% p.a. (on the outstanding amount in the beginning of the year). A Ltd. uses a cost of capital of 15% to evaluate the investments of this type. The equipment will be 33.3% p.a. (WDV). P. Securities Ltd. has agreed to give the equipment to the company on a three-year lease. The annual rental for the lease, payable in the beginning of each year, would be 4 crore. P. Securities Ltd. discounts its cash 14%. The equipment is depreciable at 33.3% p.a. (straight line method). The lessee may exercise its option to purchase the equipment for 4 crore at the termination of the lease. A Ltd. would bear all maintenance, insurance and other charges in both the alternatives. Both the companies pay 35%. You are a practicing Company Secretary. You are approached by the Managing Director of A Ltd. to help the company in evaluating the proposal. Prepare a report for the Managing Director of A Ltd. showing the effect of the lease alternative on the wealth of its shareholders. Support your answer with appropriate calculations. Present value of 1 is: Year 6% 7% 10% 14% 15% Contd... LOVELY PROFESSIONAL UNIVERSITY 51

58 Financial Management Present value of an annuity of 1 is: Year 6% 7% 10% 14% 15% Solution: Alternative: Purchase of equipment by financing it through bank loan Cost of equipment = 10,00,000 Useful life = 3 years Loan period = 3 years (payment in three equal instalments) Interest rate = 10% p.a. Scrap value after 3 years = NIL Annual repayment amount = 10,00,00,000 Annunity factor of 10% of 3 years = 10,00,00,000 2,487 = crore Year Calculation of Principal and Interest Amount Payments Principle amount Instalment at the end of the year 10% Repayment of Principal Balance Amount Calculation of Present Value of Net Cash Outflows Year Principle % p.a Balance Calculation of Present Value of Net Cash Outflows Year Loan Instalment Principal Repayment 10% ( ) % p.a (WDV) Tax 35% Net cash Outflow PV 15% PV of Nt Cash Outflows Total P.V. of net cash outflows Contd LOVELY PROFESSIONAL UNIVERSITY

59 Unit 3: Sources of Finance Alternative I: Lease the Equipment Year Lease Rent Tax 35% Net Cash Outflow PV 15% PV of Net Cash Outflows (1.40) (0.921) Total P.V of net cash outflows = 7,307 Suggestion: The present value of net cash outflows is lowest, if the equipment is purchased by taking a loan from the bank. Hence it is suggested to consider Alternative I. 3.8 Summary Financial needs of a business: The financial needs of a business may be grouped into three categories which are Long-term, Medium-term and Short-term financial needs. Long-term Sources of finance of a business include Share capital, Debentures/Bonds of different types, Loans from financial institutions and Venture capital funding Short-term Sources of finance includes Trade credit, Commercial banks, Fixed deposits for a period of 1 year or less, Advances received from customers and Various short-term provisions. In recent times in India, many companies have raised long-term finance by offering various instruments to public like deep discount bonds, fully convertible debentures, etc. In India, specialized institutions provide long-term financial assistance to industry. Bridge finance refers to loans taken by a company normally from commercial banks for a short period, pending disbursement of loans sanctioned by financial institutions. CP is a source of short-term finance to large firms with sound financial position. The venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. A lease is a contractual arrangement under which the owner of an asset agrees to allow the case of its asset by another party in exchange of periodic payments (lease-rental) for a specified period. The seed capital assistance is interest free but carries a service charge of 1% for the first five year and 10% p.a. thereafter. 3.9 Keywords Commercial Paper: It represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. Income Note: It is a hybrid security, which combines the features of both conventional loan and conditional loan. Inter-corporate Deposits (ICDs): A deposit made by one firm with another firm is known as Inter-corporate Deposits. LOVELY PROFESSIONAL UNIVERSITY 53

60 Financial Management Retained Earnings: These are the portion of earning available to equity shareholders, which are ploughed back in the company. Trade Credit: It refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business Review Questions 1. Explain the advantages of equity financing. 2. What are the advantages of debt financing from the point of the company and investors? 3. What do you mean by venture capital financing and what are the methods of this type of financing? 4. Write short notes on: (a) (b) (c) (d) Zero interest fully convertible Deep discount bonds Inflation bonds Sales tax deferments and Exemptions. 5. What are the advantages of lease financing? 6. Is Trade Credit is source of working capital finance. Discuss. 7. Taking the example of the Indian corporate, analyse the importance of issuing the CPs for the firm & to the investors. 8. Do you agree that lease is the efficient source of finance for corporates? How? 9. In your opinion, which is the best source of finance available to the firm for raising money from the public? 10. You are starting your new company & wanted to raise capital from public. Analyse the sources of finance available to you. Answers: Self Assessment short-term 3. risk 4. public issue 5. common shares 6. direct 7. debt 8. Bridge finance 9. unsecured 10. conditional 11. Income note 12. financial 13. Operating 14. IDBI 15. backward 3.11 Further Readings Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, Chandra, P., Financial Management Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p. 3. I.M. Pandey, Financial Management, 8th Edn., Vikas Publishing House Pvt. Ltd. Lawrence J. Gitman, Principles of Managerial Finance, 10th Edn., Parson Education. 54 LOVELY PROFESSIONAL UNIVERSITY

61 Unit 4: Concept of Economic Value Added Unit 4: Concept of Economic Value Added CONTENTS Objectives Introduction 4.1 Economic Value Added (EVA) 4.2 Advantages of EVA 4.3 Evaluation of EVA 4.4 Limitations of EVA Analysis 4.5 Summary 4.6 Keywords 4.7 Review Questions 4.8 Further Readings Objectives After studying this unit, you will be able to: Recognize the meaning and scope of financial management Describe the goals and objectives of financial management Explain the different Finance functions Discuss various significant aspects related to financial management Introduction Management Information System can be developed as an act of interrelated components that collect (or retrieve), process, store and distribute information to support decision-making, co-ordinate and control in an organisation. Information means data have been shaped into a form that is meaningful and useful to human being. Data are stream of raw facts reporting events occurring in organisation or physical environment before they have been organized and rearranged into a form that people can understand and use. Performance measures are a central component of management information and reporting system. It deals with performance measures for different levels of an organisation and for managers at these levels both financial and non-financial performance measures. Economic Value Added was developed to promote value-maximizing behaviour in corporate managers. It is a single, value-based measure that was intended to evaluate business strategies, capital projects and to maximize long-term shareholders wealth. 4.1 Economic Value Added (EVA) An alternative measure of financial performance in an investment centre is segment Residual Income or Economic Value Added. Economic Value Added (EVA) is the amount in rupees that remains after deducting an implied interest charge from operating income. The implied interest charge reflects an opportunity cost, and is charged on the amount of assets in each investment centre. The rate of interest charge is equal to the minimum rate on investment specified by top management as part of the corporate strategic plan. LOVELY PROFESSIONAL UNIVERSITY 55

62 Financial Management The importance of management information system has increased in recent times because of the following: 1. Emergence of global economy 2. Transformation of industrial economics knowledge and information intense products have become available. 3. Transformation of multinational enterprises 4. Emergence of digital form. Example:A division has a budgeted income of 10 lakhs and a budgeted investment of 60 lakhs. The average cost of capital for the firm is 12 per cent. The budgeted residual income is: Divisional Income 10 lakhs Interest charge 12% on 60 lakhs 7.20 Residual income/ Economic value added 2.80! Caution Different interest rates may be applied to different components of investment like fixed assets, inventories, receivables and cash. During the 1990s, residual income has been refined and remained as Economic Value Added (EVA) by Stern Steward Counseling Organization and they have registered EVA (TM) as their trademark. The EVA concept extends the traditional residual income measures by incorporating adjustments to the divisional performance measures against distortions introduced by generally accepted accounting principles (GAAP). EVA can be defined as = Conventional divisional profit ± Accumulated adjustment Cost of capital charge on divisional assets. Adjustments are made to the chosen, conventional divisional profit measures in order to replace historical accounting data with a measure of economic profit and asset values. Stern Stewart has developed approximately 160 accounting adjustments but most organisations will only need to use about 10 of the adjustments. These adjustments result in the capitalization of many discretionary adjustments such as research and development, marketing and advertising by spreading these costs over the periods in which the benefits are received. Therefore, adopting EVA reduces some of the harmful side effects arising from using financial measures. Also, because it is restatement of the residual income measure compared to ROI, EVA is more likely to encourage goal congruence in terms of asset acquisition and disposal decisions. Managers are also made aware that capital has a cost and they are thus encouraged to dispose of underutilized assets that do not generate sufficient income to cover their cost of capital. There are a number of issues that apply to ROI, residual income or its replacement (EVA). They concern determining which assets should be included in a divisions asset base 56 LOVELY PROFESSIONAL UNIVERSITY

63 Unit 4: Concept of Economic Value Added and adjustments that should be made to financial accounting practices to derive managerial information that is closer to economic reality. EVA = [Profit after Tax + Interest (1 marginal tax rate of the firm)] Cost of capital Economic book value of the capital employed in the firm EVA = Profit after Tax Cost of equity Equity employed in the firm EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It may be calculated in any of the following apparently different but essentially equivalent ways: EVA = Net operating profit other tax Cost of capital Economic book value of capital employed in the firm. EVA = Economic book value of capital employed in the firm (Return in capital Cost of capital) Self Assessment Fill in the blanks: 1. is the amount in rupees that remains after deducting an implied interest charge from operating income. 2. EVA is essentially the.left after making an appropriate charge for the capital employed in the business. 3. The implied interest charge reflects a cost. 4. The rate of interest charge is equal to the minimum rate on..specified by top management as part of the corporate strategic plan. 4.2 Advantages of EVA 1. EVA combines profit centre and investment centre concepts. With EVA, management establishes a target profit or target rate of return for the business segment. Any income in excess of the target level is the residual income/eva. To illustrate, the target rate of return for DD Ltd., is 20 per cent on total net assets. Total net assets are 800,000 and actual net income 200,000 so the target net income is 800, = 160,000. The EVA for the company is actual net income minus target net income = 200, ,000 = 40, In case of EVA, different interest rates may be used for different types of assets e.g., low rates can be used for inventories while a higher rate can be used for investments in fixed assets. Furthermore, different rates may be used for different of fixed assets to take into account different degrees of risk. 3. With EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other hand provides different incentives for investments across business units. 4. The EVA in contrast to ROI has a stronger positive correlation with changes in company s market share. Shareholders are important stakeholders in a company s market value. 5. EVA eliminates economic distortions of GAAP to focus decisions on real economic results. 6. Provision of correct incentives for capital allocations. LOVELY PROFESSIONAL UNIVERSITY 57

64 Financial Management 7. EVA provides for better assessment of decisions that affect balance sheet and income statement or trade-offs between each through the use of the capital charge against NOPAT. 8. Long-term performance that is not compromised in favor of short-term results. 9. EVA decouples bonus plans from budgetary targets. 10. EVA covers all aspects of the business cycle. 11. EVA aligns and speeds decision making, and enhances communication and teamwork. 12. Provision of significant information value beyond traditional accounting measures of EPS, ROA and ROE. 13. Goal congruence of managerial and shareholder goals achieved by tying compensation of managers and other employees to EVA measures. 14. Annual performance measured tied to executive compensation. Did u know?cola-cola is one of the many companies that adopted EVA for measuring its performance. Its aim, which was to create shareholders wealth, was announced in its annual report. Coca-Cola CEO Roberto Goizueta accredited EVA for turning Coca-Cola into the number one Market Value Added Company. Coca-Cola s stock price increased from $3 to over $60 when it first adopted EVA in the early 1980s. In 1995, Coca-Cola s investor received $8.63 wealth for every dollar they invested. Self Assessment Fill in the blanks: 5. EVA eliminates economic distortions of.to focus decisions on real economic results 6. In case of EVA, interest rates may be used for different types of assets 7. EVA combines profit centre and concepts. 8. EVA decouples bonus plans from..targets 4.3 Evaluation of EVA Economic Value Added (EVA) vs. Earning Per Share (EPS) EPS is calculated by dividing the net profits after interest, depreciation and taxation by the number of equity shares issued by the company to find out the profits earned per share. This measure is flawed because it does not consider the equity cost of capital employed (i.e. it assumes that equity capital comes to the company for free). Naturally, when more funds are pumped into the company, the size of the business increases without necessary increasing the profitability. Also, EVA takes into consideration the total capital employed by the company total shareholders fund (equity and accumulated profits) and total debt and finds out the difference between the earning and the cost of the capital employed. Did u know? EPS can be improved without corresponding improvement in performance simply by issuing further equity at a premium. 58 LOVELY PROFESSIONAL UNIVERSITY

65 Unit 4: Concept of Economic Value Added Differences between ROI and EVA Business Unit Current Assets Table 4.1: ROI Method Fixed Assets Total Investment Budgeted Profit ROI Objective A % B C D E (1.8) (5) Business Unit Profit Potential Current Assets Rate Table 4.2: EVA Regd. Ergs. on C/Assets F/A Rate Regs. Ergs. for F/A Budgeted EVA (1) (2) (3) (4) (5) (6) (7) (1)-(4)-(7) A % % B C D (1.6) E (1.8) (3.8) From, first portion of the calculation (ROI method) one can observe that only one business unit C is ROI objective consistent with the company wide cut off rate, and in no unit is the objective consistent with the company wide 4 per cent cost of carrying Current Assets. Business unit A would decrease its chances of meeting its profit objective, if it did not earn at least 20 per cent on added investments in either Current Assets or Fixed Assets, whereas units D and E would benefit from investments with a much lower return. The EVA method (2nd portion of the calculation EVA Method) correct these inconsistencies in the following manner the investments, multiplied by appropriate rates are subtracted from the budgeted profit. The resulting amount is the budgeted EVA. Periodically, the actual EVA is calculated by subtracting from the actual profits, the actual investment multiplied by the appropriate rates. Self Assessment Fill in the blanks: 9. EPS measure is flawed because it does not consider the.of capital employed. 10. EVA takes into consideration the total capital employed by the company total shareholders fund and 11. EVA finds out the difference between the.and the cost of the capital employed. 4.4 Limitations of EVA Analysis 1. The EVA analysis does not necessarily eliminate the problem of comparing the performance of large and small divisions. For example, a company has three divisions, LOVELY PROFESSIONAL UNIVERSITY 59

66 Financial Management each of which earns a 25 per cent return on its total net assets. However, the EVA of the divisions is significantly different. Below are the data for three divisions: Table 4.3: Division X Y Z Total net assets 100, , ,000 Net income 25, , ,000 ROI on net assets 25% 25% 25% Target net income (15% of net assets) 15,000 75, ,000 EVA (net income target net income) 10,000 50, ,000 Each division earned the same rate of return on net assets, and each has the same percentage target net income requirement. Still the EVA measures are dramatically different among the divisions. This approach has a tendency to highlight the divisions that generate the largest rupee profits for the firm. 2. Most of the problem in measuring the divisional income and divisional investment base are also present in the measurement of EVA. 3. There is additional risk of selecting a fair and equitable measure of the required cut-off percentage (i.e., the cost of capital). 4. EVA can be readily transformed into ROI and many firms tend to convert EVA into ROI. The relationship between EVA and ROI is as follows: ROI = EVA K 1 Where, ROI = Return on investment EVA = Economic Value Added I = Investment K = Cost of capital The two methods however, may show different results. In face of such a conflict, a question may arise: which of two must be considered more reliable? Task Taking the example of different companies, analyze how the corporates have used EVA model. Illustration: Income Statement Net Sales 2, Cost of Goods Sold 1, SG&A Expenses Depreciation LOVELY PROFESSIONAL UNIVERSITY

67 Unit 4: Concept of Economic Value Added Other Operating Expenses Operating income Interest Expenses Income Before Tax Income Tax (25%) Net Profit After Taxes Common Balance Sheet Current Assets Current Liabilities Cash Accounts Payable (A\P) Receivable (A/R) Accrued Expenses (A\E) Inventory Short-Term Debt Other Current Assets Total Current Liabilities Total Current Assets Long-Term Liabilities Fixed Assets Long-Term Debt Property, Land Total Long-Term Liabilities Equipment Capital (Common Equity) Other Long-Term Assets Capital Stock Total Fixed Assets 1, Retained Earnings Year to Date Profit/Loss Total Equity Capital Total Assets 2, Total Liabilities 2, Calculate Net Operating Profit After Tax (NOPAT) 2. Identify company s Capital (C) 3. Determine a reasonable Capital Cost Rate(CCR) 4. Calculate company s Economic Value Added (EVA) Solution: Step 1: Calculate Net Operating Profit After Taxes (NOPAT) Net Sales 2,600 (A) Cost of Goods Sold 1, SG&A Expenses Depreciation Other Operating Expenses Operating income Tax (25%) NOPAT LOVELY PROFESSIONAL UNIVERSITY 61

68 Financial Management Note: This NOPAT calculation does not include the tax savings of debt. Companies paying high taxes and having high debts may have to consider tax savings effects, but this is perhaps easiest to do by adding the tax savings component later in the capital cost rate (CCR). An alternative way to calculate NOPAT: Net Profit After Tax Interest Expenses NOPAT Step 2: Identify Company s Capital (C) Company s Capital (C) are Total Liabilities less Non-Interest Bearing Liabilities: Total Liabilities 2, less Accounts Payable (A/P) Accrued Expenses (A/E) Capital (C) 2, Step 3: Determine Capital Cost Rate (CCR) In this example: CCR = 10% Because, Owners expect 13% return for using their money because less are not attractive to them; this is about the return that investors can get by investing long-term with equal risk (stocks, mutual funds, or other companies). Company has 940/2350 = 40% (or 0.4) of equity with a cost of 13%. Company has also 60% debt and assume that it has to pay 8% interest for it. So the average capital costs would be: CCR = Average Equity Proportion Equity Cost + Average Debt Proportion Debt cost = 40% 13% + 60% 8% = % % = 10% Note: CCR depends on current interest level (interest higher, CCR higher) and company s business (company s business more risky, CCR higher). Note: If tax savings from interests are included (as they should if we do not want to simplify), then CCR would be: CCR = 40% 13% + 60% 8% (1 tax rate) = % % (1 0.4) = 8.08% (Using 40% tax rate) Step 4: Calculate Company s EVA This company created an EVA of 210. EVA = NOPAT C CCR = , = Note: This is the EVA calculation for one year. If a company calculates EVA, e.g., for a quarterly report (3 months) then it should also calculate capital costs accordingly: Capital costs for 3 months: 3/12 10% 2,000 = 50 Capital costs for 4 months: 4/12 10% 2,000 = 67 Capital costs for 6 months: 6/12 10% 2,000 = 100 Capital costs for 9 months: 9/12 10% 2,000 = LOVELY PROFESSIONAL UNIVERSITY

69 Unit 4: Concept of Economic Value Added The Complete Procedure: Calculate EVA in the Internal Reporting Net Sales 2, Cost of Goods Sold -1, SG&A Expenses Depreciation Other Operating Expenses Operating income Tax (25%) NOPAT Capital costs (10% * 2000) Economic Value Added (EVA) Note: In this example (for one year) the capital costs are calculated on a yearly basis. E.g. capital costs for 3 months: 3/12 10% 2,000 = 50 Self Assessment Fill in the blanks: 12. Most of the problem in measuring the divisional income and divisional..base are also present in the measurement of EVA. 13. EVA can be readily transformed into The relationship between EVA and ROI is ROI =. 15. EVA analysis does not necessarily eliminate the problem of comparing the performance of and..divisions. Case Study Case: Economic Value Added In economics, the value addition is calculated by the following formula: Value Added = Value of sales less the cost of bought-in goods and services. In this formula, only cost of bought-in goods and services has been accounted for. It completely ignores labour cost, depreciation, markup etc. In fact, they are factors of production (land, labour and capital). They provide services which raise value of inputs to a much higher realized value. The difference would be shared among them. Calculate the value added & the value distributed in the below case. Sales of the company Out-side purchases Workers salary Bankers Contd... LOVELY PROFESSIONAL UNIVERSITY 63

70 Financial Management Government Owners Firms deprecation Retained earnings Indus Machine Tools Ltd. is a Private Ltd Company at Multan, a city in Punjab, Pakistan. Its Balance Sheet is given below: Indus Machines Tools Ltd. Balance Sheet as on 31st Dec08 Liabilities Assets Accounts payable Cash 4940 Bank overdraft Raw material stock Long term debt Finished goods stock Equity Account receivables Fixed assets Total Total Additional Information Taxes accounts for 685, 440/-, Total costs is 1148, 400/-, effective returns on debt- 7.5 %, equity- 20% & bank loan is 10.8%. Questions 1. Calculate the NOPAT & total capital. 2. What is the return on capital? 3. From the given details, calculate the cost of capital. 4. Analyse the financial position of the company by calculating the EVA. 5. Do you think the company will be getting the desired equity investment if it plans to go for expansion? Why? 4.5 Summary Economic Value Added (EVA) is the amount in rupees that remains after deducting an implied interest charge from operating income. The EVA concept extends the traditional residual income measures by incorporating adjustments to the divisional performance measures against distortions introduced by generally accepted accounting principles (GAAP). EVA is more likely to encourage goal congruence in terms of asset acquisition and disposal decisions. In case of EVA, different interest rates may be used for different types of assets e.g., low rates can be used for inventories while a higher rate can be used for investments in fixed assets. The EVA in contrast to ROI has a stronger positive correlation with changes in company s market share. EVA decouples bonus plans from budgetary targets. The EVA analysis does not necessarily eliminate the problem of comparing the performance of large and small divisions. EVA can be readily transformed into ROI and many firms tend to convert EVA into ROI. 64 LOVELY PROFESSIONAL UNIVERSITY

71 Unit 4: Concept of Economic Value Added 4.6 Keywords Capital Employed: It is the capital investment necessary for a business to function. Corporate Finance: It is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. Economic Value Added: It is an estimate of economic profit by after making adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. Net Asset Value: It is a term used to describe the value of an entity s assets less the value of its liabilities. NOPAT: It is a company s after-tax operating profit for all investors, including shareholders and debt holders. 4.7 Review Questions 1. Why is performance measurement required in management control system? 2. Elucidate the advantages which a firm will obtain by using EVA approach. 3. EVA results in increasing the shareholders wealth. Do you agree? Justify. 4. Comment on the major applications of EVA. 5. Analyse the need for EVA in today s competitive scenario. 6. Elucidate how EVA is much better & efficient approach than other traditional approaches. 7. Successful implementation of EVA requires a substantial commitment by managers and employees at all levels of an organisation. Comment. 8. Critically appraise the Economic value added approach. 9. Given sales of a company- 4,500,000/-, cost of goods- 2,857,600/- & tax paid by the firm is 50000/-. Calculate NOPAT from the given data. 10. If XYZ employs a total capital of 15,896,000 & return on capital is 15%. The cost of capital is 12%. Calculate EVA. Answers: Self Assessment 1. Economic Value Added (EVA) 2. surplus 3. opportunity 4. investment 5. GAAP 6. different 7. investment centre 8. budgetary 9. equity cost 10. total debt 11. earning 12. investment 13. ROI 14. EVA K 15. large, small Further Readings Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2. Chandra, P., Financial Management Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p. 3. LOVELY PROFESSIONAL UNIVERSITY 65

72 Financial Management Unit 5: Risk and Return Analysis CONTENTS Objectives Introduction 5.1 Risk and Return Characterization Return Defined Risk Preferences 5.2 Risk Measurement Risk Assessment Probability Distribution Risk Measurement Quantitatively 5.3 Portfolio Theory and Risk Diversification Portfolio Return and Standard Deviation Measuring Portfolio Risk Variance of a Portfolio Minimum Variance Portfolio 5.4 Portfolio Risk and Correlation Portfolio Risk N-Security Case Systematic and Unsystematic Risk 5.5 Capital Asset Pricing Model (CAPM) Assumptions of CAPM Interpreting Beta Limitations of CAPM 5.6 Summary 5.7 Keywords 5.8 Review Questions 5.9 Further Readings Objectives After studying this unit, you will be able to: Recognize the concept of risk and return and determine their relationship Differentiate relevant and irrelevant risk Explain the measurement of risk Describe the use of Capital Asset Pricing Model (CAPM) 66 LOVELY PROFESSIONAL UNIVERSITY

73 Unit 5: Risk and Return Analysis Introduction In the most basic sense, risk is the chance of financial loss. Assets having greater chances of loss are considered as more risky than those with lesser chances of loss. More formally, the term, risk, is used synonymous with uncertainty in terms of variability of returns associated with a given asset. As for example, interest of 600 on Govt. Bond of 10,000 for 1 year since there is no variability associated with interest, it is considered as risk-free. Whereas 10,000 investment in equity shares over 1 year period may give return anywhere between 0 to It is considered risky because of high variability in its return. 5.1 Risk and Return characterization Some risks directly affect both finance managers and the shareholders whereas some risks are from specific and some are shareholders specific. These are given below: Box 5.1: Specific Risks Business Risk Financial Risk Interest Rate Risk Liquidity Risk Market Risk Firm Specific Risk The chance that the firm will be able to cover its operating costs. Level is drawn by the firms revenue stability and the structure of its operating cost (fixed vs. variable). The chance that the firm is available to cover its financial obligations. Level is drawn by the predictability of the firm s operating cash flows and its fixed cost financial obligations like interest on debt/bond. Shareholder Specific Risk The chance that changes in interest rate will adversely affect the value of an investment. Most investments lose value when the interest rate rise and increase in value when it falls. The chance that an investment can be converted into money at a reasonable price Liquidity is significantly affected by the size and departments of the markets in which an investment is normally traded. The chance that the value of an investment will decline because of market factors that are independent of investment (such as economic, political and social events). The more the value of the given investment responds to market uncertainties, the greater its risk and the less it refunds, the smaller the risk. Box 5.2: Firm and Shareholders Risk Event Risk Exchange Rate Risk Purchasing Power Risk Tax Risk The chance that a totally unexpected event will have a significant effect on the value of the firm or a specific instrument. These events, such as government s withdrawal of a popular prescription along with affect only a small group of firms or investments. This is future cash flow getting affected by fluctuation in the currency exchange rate. The greater the chance of an unexpected exchange rate fluctuation the greater the risk of cash flows and therefore the lower the value of the firm or investment. The chance that changing price levels due to inflation or deflation in the economy, will adversely affect the firms or investments cash flows and values. Typically, firms or investments with cash flows that moves with general price levels have a low purchasing power risk and those with cash flows that do not make with general price levels have high purchasing power risk. The chances that with adverse change in tax laws firm and investment values change adversely are considered more risky. LOVELY PROFESSIONAL UNIVERSITY 67

74 Financial Management Return Defined If we are going to assess risk on the basis of variability of return, we need to be certain what return is and how to measure it. The return is the total gain or loss experienced on an investment over a given period of time. It is measured as cash distributions (either dividend or interest) during the period plus the change in value expressed as a percentage of value of the investment at the beginning of the period. For Example, suppose one buys a security for 100 and receives 10 in cash and is worth 110 one year later. The return would be ( )/ 100 = 20 per cent. Thus, return accrues from two resources, income plus price appreciation (or loss in price). The expression for calculating the rate of return earned on any asset over period t, k t can be defined as: K t = C + P - P P t t t-1 t-1 Where, K t = actual, expected or required rate of return during period t C t P t = Cash flow received from the investment during time period t 1 to t = Price (value) of asset at time t P t 1 = Pric e (value) of asset at time t 1 Example: X, a high traffic video arcade wants to determine the return on its two video machines C and D. C was purchased 1 year back for 200,000 and currently has a market value of 215,000. During the year, it generated 8000 cash receipts. D was purchased 4 years ago, its value in the year declined from 120,000 to 118,000. During the year, it generated 17,000 cash receipts. The annual rate of return of C and D will be as follows: For C = For D = , = = 11.5% 200, , , = = 12.5% 120, ,000 It may be noted that though market value of D declined during the year, its cash flow enabled it to earn higher rate of return than C during the same period Risk Preferences Perception of risk varies among managers and firms. The three basic risk preference behaviour is identified risk averse, risk indifferent and risk seeking. 1. For the risk indifferent manager, the expected return does not change as risk increases from one level to another. In essence, no change in return is expected for the increase in risk. 2. For the risk average manager, the expected return increases for an increase in risk. These managers shy away from risk and hence expectations of return go up to compensate for taking greater risk. 3. For the risk-seeking managers, the expected return decreases with increase in risk. Because they enjoy risk, these managers are willing to give up some return to assume more risk. However, such behaviour is not likely to benefit the firm. 68 LOVELY PROFESSIONAL UNIVERSITY

75 Unit 5: Risk and Return Analysis Did u know? Most managers are risk averse for a given increase in risk, they expect increase in return. They generally tend to be conservative rather than aggressive when accepting risk for their firm. Self Assessment Fill in the blanks: 1. The chance that the firm is available to cover its financial obligations is known as. risk. 2..is measured as cash distributions during the period plus the change in value expressed as a percentage of value of the investment at the beginning of the period. 3. For the.manager, the expected return does not change as risk increases from one level to another. 5.2 Risk Measurement The concept of risk can be developed by considering a single asset in isolation. We can see the expected return behaviour to assess risk and statistics can be used to measure it. Sensitivity analysis and probability distribution can be used to assess the general level of risk associated with a single asset Risk Assessment Sensitivity Analysis or Scenario Analysis uses several possible return estimates to ascertain the extent of variability among outcomes. One common method is to have pessimistic (worst), most likely (expected) and optimistic (best) estimates of the return associated with a given asset. In this case, the assets risk can be measured by the range of returns. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The greater the range, the more variability or risk, the asset is said to have. Example: N Co. wants to choose the better of two investments A and B. Each require an initial outlay of 100,000 and each has a most likely annual rate of return of 15%. Management has made pessimistic and optimistic estimates of returns associated with each as follows: Asset A Asset B Initial investment 100, ,000 Annual rate of return Pessimistic Most likely Optimistic 13% 15% 17% Asset A appears to be less risky than asset B, its range of (17% 13%) 4% is less than the range of 16% (23% 7%) for asset B. The risk averse decision maker would prefer Asset A over Asset B. Since A offers the same most likely return as B (15%) with lower risk (smaller range). Although the use of sensitivity analysis and range is rather simple, it doesn t give the decisionmaker a feel for variability of returns that can be used to estimate the risk involved. 7% 15% 23% LOVELY PROFESSIONAL UNIVERSITY 69

76 Financial Management Probability Distribution Probability distribution provides a more quantitative insight into an assets risk. The probability of a given charge is its chance of occurring. An outcome with probability of 80% occurrence is expected 8 out of 10 times. An outcome with probability of 100% is certain to happen. Outcomes with probability of zero will never occur. A probability distribution is a model that relates probabilities to the associated outcomes. The simplest type of probability distribution is the bar chart, which only shows a limited number of outcomes. The bar charts for N company Asset A and Asset B are shown in Figure 5.1. Although both assets have the same must likely returns, the range of return is much greater or more dispersed for Asset B than for Asset A 16 per cent versus 4 per cent. Figure 5.1: Possible Outcomes and Associated Probabilities Probability of Occurences Probability of Occurences Return % Return % If we know all the possible outcomes and associated probabilities we can develop a continuous probability distribution. This type of distribution can be presented as a bar chart for a very large number of outcomes. Figure 5.2: Continuous Probability Distribution for Asset A and Asset B Asset A Probability Density Asset B Return % The figure presents continuous probability distribution for asset A and Asset B. Note that although assets A and B have the most likely return (15 per cent), the distribution of returns for assets B has much greater dispension than that for Asset A. Clearly asset B is more risky than Asset A. 70 LOVELY PROFESSIONAL UNIVERSITY

77 Unit 5: Risk and Return Analysis Risk Measurement Quantitatively The risk of asset in addition to range can be measured quantitatively by using statistical methods the standard deviation and the co-efficient of variation. Standard Deviation The most common statistical indicator of an asset s risk is the standard deviation (6k) which measures the dispension around the expected value k. The expected value of a return (k) is the most likely return on a given asset and is calculated as: K = n å i= 1 (k P ) i i where k i = return for the ith outcome P i = probability of occurrence of ith income The expression of Standard Deviation of returns (6k) N = number of outcomes considered 6K = å i i= 1 (k - k) P i where represents the square root. The square of the standard deviation (6k) 2 is known as variance of the distribution. Co-efficient of Variation The coefficient of variation (CV) is a measure of relative dispension that is useful in comparing the risk of assets with differing expected returns. Thus coefficient of variation (CV) is 6k S tandard Deviation of Returns CV = = K Expected value of a return Did u know? The higher the coefficient of variation, the greater the risk. Example: The probability distribution of returns for assets A and B Assets A Assets B Returns Probability Returns Probability 13% % % % 01 25% 0.2 Calculate the expected value, the standard deviation and the coefficient of variation of returns in respect of Asset A and Asset B. Which of these mutually exclusive assets do you prefer and why? LOVELY PROFESSIONAL UNIVERSITY 71

78 Financial Management Asset A Standard Deviation = Asset B Standard Deviation = 6.5 Coefficient of Variation of Returns of Asset A = S tandard Deviation Expected Re turns = = Coefficient of variation of return of Asset B = = 0.42 The higher the coefficient of variation, the more risky the asset returns are. Returns of Asset B is therefore more risky than returns of Asset A. Self Assessment Fill in the blanks: 4. Sensitivity analysis and can be used to assess the general level of risk associated with a single asset. 5. A..is a model that relates probabilities to the associated outcomes. 6. The...is a measure of relative dispension that is useful in comparing the risk of assets with differing expected returns. 5.3 Portfolio Theory and Risk Diversification The portfolio theory provides a normative approach to investor s decision to invest in assets or securities under risk. It is based on the assumption that investors are risk averse. This implies 72 LOVELY PROFESSIONAL UNIVERSITY

79 Unit 5: Risk and Return Analysis that investors hold well diversified portfolio instead of investing in a single asset or security. A portfolio as the name signifies, is a bundle or a combination of individual assets or securities. Hence individuals concern should be on the expected return and risk of the portfolio rather than on individual assets or securities. The second assumption of the portfolio theory is that the returns of securities are normally distributed. This means that the expected value (mean) and variance (or standard deviation) analysis is the foundation of the portfolio decisions Portfolio Return and Standard Deviation The return of a portfolio is equal to the weightage average of the returns of individual assets or securities in the portfolio with weights being equal to the proportion of investment in each asset. Example: Suppose you have the opportunity of investing your wealth either in asset X or asset Y. The possible outcomes of the two assets indifferent states of economy are given below: The expected rate of return of an individual asset: The expected rate of return of X is K = (already seen earlier) k x = ( 8 0.1) + (10.2) + (8 0.4) + (5 0.2) + ( 4 0.1) = 5% and of Y = k y = (14 0.1) + ( 4 0.2) + (6 0.4) + (15 0.2) + (20 0.1) = 8% Suppose you decide to invest 50% on X and 50% in Y. Since we know the expected rate of return of X (5 per cent) and Y (8%) and their weights (50% each) we can calculate the expected rate of return on the portfolio as the weighted average of the expected rates of return of X and Y. i.e = 6.5% Thus, we can conclude the return on a portfolio is a weightage average of the returns on the individual assets from which it is formed. The portfolio return K p = W 1 k 1 + W 2 k W n k n = n W1 ki i 1 Where W i = proportion of the portfolio rupee value represented by asset; k i = return on asset LOVELY PROFESSIONAL UNIVERSITY 73

80 Financial Management n Of course 1 which represents that 100 per cent of portfolio assets must be included in this i 1 computation. Portfolio Risk Two Asset Case Individual assets or securities are more risky than portfolio. How is the risk of portfolio measured? As discussed earlier risk is measured in terms of variance in standard deviation. The standard deviation of a portfolio s return is found by applying the formula for standard deviation of a single asset. Example: There are two investment opportunities A and B The expected rate of return, variance and standard deviation of A are: And of B Return = = 20% Standard Deviation 2 = 0.5 (40 20) (0 20) 2 = 400 Standard Deviation = % Return = = 20% Standard Deviation 2 = 0.5 (0 20) (40 20) 2 = 400 Standard Deviation = % Both A and B have the same expected rate of return (20 per cent) and same variance (400) and Standard Deviation (20 per cent). Thus, they are equally risky. If the portfolio consisting of equal amount of A and B is constructed, the portfolio return would be = 20%, same as the expected return from individual securities but without risk; why? If the economic conditions are good, then A would yield 40 per cent and zero and the portfolio return will be = 20%. When the economic conditions are bad, then A s return will be zero and B s 40 per cent and the portfolio return will be the same = 20%. Thus, by investing equal amount in both A and B, the investor is able to eliminate the risk altogether and assumed of a return of 20 per cent with a 0.5 x x 20 = 20%, same as the expected return from individual securities but without risk; why? If the economic conditions are good, then A would yield 40 per cent and zero and the portfolio return will be = 20%. When the economic conditions are bad, then A s return will be zero and B s 40 per cent and the portfolio return will be the same = 20%. Thus, by investing equal amount in both A and B, the investor is able to eliminate the risk altogether and assumed of a return of 20 per cent with a zero standard deviation. 74 LOVELY PROFESSIONAL UNIVERSITY

81 Unit 5: Risk and Return Analysis Measuring Portfolio Risk Like in the case of individual assets or securities, the risk of a portfolio can be measured in terms of variance or standard deviation. The portfolio variance is affected by the association of movement of returns of two securities. Covariance of two securities measures their comovements. Three steps are involved in the calculation of covariance between two securities: 1. Determine the expected returns for securities. 2. Determine the deviation of possible returns for each security. 3. Determine the sum of the product of each deviation of returns of two securities and probability.! Caution The variance or standard deviation of the portfolio is not simply the weighted average of variances or standard deviations of individual securities. Let us consider the data of securities X Y given in Example 4. We have seen that the expected return for security X is 5% and for security Y is 8%. Calculations of variations from the expected return and covariance products of deviations of returns of securities X and Y and the associated probabilities are given below: State of Economy Co-variance of Returns of Securities X and Y Probability Returns % Deviations from expected Return X Y X Y Product of Deviation & Probability A B C D E Covariance 33.0 The covariance of returns of securities X and Y is 33. We can use the following formula for computing covariance: Covxy = n i 1 P (kx kx) (ky ky) 1 Where CoVxy is the variance of returns of securities X and Y, kx and ky returns of securities X and Y respectively, Kx and Ky. It may be observed from the calculation of covariance of returns of securities X and Y that is a measure of both the standard deviations of the securities and their association. Thus, covariance can be calculated as follows: Covariance XY = Standard Deviation X Standard Deviation Y Correlation XY Covxy = 6x 6y Corxy Where 61 and 62 are standard deviation returns for securities X and Y and Corxy is the correlation coefficient of securities X and Y. Correlation measures the linear relationship between two variables (in this case X and Y securities). LOVELY PROFESSIONAL UNIVERSITY 75

82 Financial Management Thus, correlation coefficient of securities X an Y can be computed as: Correlation XY = Con variance XY S tandard Deviation X S tandard Deviation Y Or, Cor xy = Cov xy 6x6y The variances and standard deviation of X and Y are as follows: 6x 2 = 0.1 ( 8 5) (10 5) (8 5) (5 5) ( 4 5) 2 = = x = 33.6 = 5.80% 6y 2 = 0.1 (14 8) ( 4 8) (6 8) (15 8) (20 8) 2 = = y = 58.2 = 7.63% The correlation coefficient of securities X and Y is as follows: = = Securities X and Y are negatively correlated. If an investor invests in the combination of these securities, risk can be reduced Variance of a Portfolio The variance of two security portfolio is given by the following equation: 6p 2 = 6 2 xwx ywy 2 + 2wx wy 6x 6y Cor xy where, 6p = Standard deviation of the portfolio wx and wy are the weightage of securities in value. If we assume wx and wy in our above example as 50 : 50, then we get 6p 2 = 33.6 (0.5) (0.5) = = 6.44 and standard deviation = 6.44 = 2.54% Minimum Variance Portfolio A portfolio that has the lowest level of risk is referred as the optimal portfolio. A risk averse investor will have a trade-off between risk and return. We can use the following formula for estimating optimal weights of securities X and Y. Wx* = 6y 2 - Covxy 2 2 6x + 6x - 2Covxy 76 LOVELY PROFESSIONAL UNIVERSITY

83 Unit 5: Risk and Return Analysis Where Wx* is the proportion of investment in security X (since the variance in Security X is lower than Y). Investment in Y will be 1 Wx*. In the above example, we find Wx* = (-33) 91.2 = ( -33) = Thus, the weight of Y will be = The portfolio variance (with 57.8 per cent of investment in X and 42.2 per cent in Y) is: 6p 2 = 33.6 (0.578) (0.422) 2 + 2(0.578) (0.422) (5.80) (7.63) ( 746) 6p 2 = = 5.48 Any other combination of X and Y will yield a higher variance. (In the earlier example of 50% and 50% weights, we have seen the variance as 6.44) Self Assessment Fill in the blanks: 7. The return of a portfolio is equal to the..of the returns of individual assets. 8. A portfolio that has the lowest level of risk is referred as the.portfolio. 9. The portfolio is affected by the association of movement of returns of two securities. 5.4 Portfolio Risk and Correlation The risk of portfolio of X and Y has considerably reduced due to the negative correlation between returns of securities X and Y. The above example shows that risk can be reduced by investing in more than one security. However, the extent of benefits of portfolio diversification depends on the correlation between returns of securities. The correlation coefficient will always be between +1 and 1. Returns of securities vary perfectly when the correlation coefficient is and is perfectly opposite direction when it is 1.0. A zero correlation coefficient implies that there is no relationship between the return of securities. In practice, the correlation coefficients of returns of securities may vary between +1 and 1. How the portfolio variance is affected by the Correlation Coefficient can be explained by an example. Example: Securities M and N are equally risky but they have different expected returns: Km = m = 0.04 Kn = n = 0.20 Wm = 0.50 ám = 0.20 Wn = n= 0.04 What is the portfolio variance if (a) Cormn = = +1.0, (b) Cormn = 1.0 (c) Cormn = and (d) Cormn 0.10 Perfect Positive Correlation When the returns of two securities M and N are perfectly positively correlated the portfolio variance will be 6p 2 = 0.04 (0.5) (0.5) (0.5)(0.5) (1.0)(0.2)(0.2) = = 0.04 The portfolio variance is just equal to the variance of individual securities. Thus, the combination of securities M and N is as risky as the individual securities. LOVELY PROFESSIONAL UNIVERSITY 77

84 Financial Management Perfect Negative Correlation If the returns of securities M and N are perfectly negative correlative the portfolio variance will be: 6p 2 = 0.04 (0.5) (0.5) + 2 (0.5)(0.5) ( 1.0)(0.2)(0.2) = = 0 The portfolio variance is zero. The combination of securities M and N completely reduces the risk. Weak Positive Correlation: The portfolio variance under weak positive correlation (+0.10) is given below: 6p 2 = 0.04 (0.5) (0.5) (0.5)(0.5) (0.1)(0.2)(0.2) = = The portfolio variance is less than the variance of individual securities. Weak Negative Correlation The portfolio variance under weak negative correlation ( 0.10) is given below: 6p 2 = 0.04 (0.5) (0.5) (0.5)(0.5) ( 1.0)(0.2)(0.2) = = The portfolio variance has reduced more than when the returns were weak positive correlated Portfolio Risk N-Security Case We have so far discussed the computation of risk when a two security portfolio is formed. The calculations of risk becomes quite involved when a large number of securities are combined to form a portfolio. Based on the logic of the portfolio risk in a two security case, the portfolio risk (measured as variance) in N security can be calculated as follows: 6p 2 = n(1/n) 2 average variance (+n 2 n) (1/n) 2 average covariance = (1/n) average variance + (1 1/n) average covariance It may be noted that the first term on the right hand side (1/n) will become insignificant when n is very large and thus the positive variance will become approximately equal to average covariance Systematic and Unsystematic Risk Risk has two parts. A part of the risk arises from the uncertainties which are unique to individual securities and which is diversifiable if large number of securities are combined to form well diversified portfolios. The unique risk of individual securities in a portfolio cancel out each other. This part of the risk can be totally reduced through diversification and is called unsystematic or unique risk. The examples of unsystematic risk are: 1. The company loses a big contract in a bid. 2. The company makes a breakthrough in process innovation. 3. The R&D expert of the company leaves. 4. Workers declare strike in a company. 5. A formidable competitor enters the market. 78 LOVELY PROFESSIONAL UNIVERSITY

85 Unit 5: Risk and Return Analysis 6. The government increases customs duty on the material used by the company. 7. The company is not able to obtain adequate quantity of raw materials from the suppliers. The other part of the risk arises on account of economywide uncertainties and the tendency of individual securities to move together with changes in the market. This part of the risk cannot be reduced through diversification and it is called systematic or markets risk. The examples of systematic risk are: 1. The government changes the interest rate policy. 2. The corporate tax rate is increased. 3. The government resorts to massive deficit financing. 4. The inflation rate increases. 5. The Reserve Bank of India announces a restrictive credit policy. Investors are exposed to market risk even when they hold well diversified portfolios of securities. Total risk, which in the case of an individual security, is the variance (or standard deviation) of its return can be divided into two parts. Self Assessment Fill in the blanks: Total risk = Systematic risk + Unsystematic risk 10. The extent of benefits of portfolio diversification depends on the..between returns of securities. 11. Part of the risk that cannot be reduced through diversification is called or markets risk. 12. The..will always be between +1 and Capital Asset Pricing Model (CAPM) CAPM provides a framework for measuring the systematic risk of an individual security and relates it to the systematic risk of a well diversified portfolio. In the context of CAPM, the risk of an individual security is defined as the volatility of the security s return vis-à-vis the return of a market portfolio. The risk (volatility) of individual securities is measured by (beta). Beta is a measure of a security s risk relative to the market portfolio. Since diversifiable risk does not matter, beta is thus a measure of systematic risk of a security. Risk free security has no volatility and it has a zero beta: The Capital Asset Pricing Model is given in equataion: K 1 = R f + 1 (km Rf) Where K 1 = required rate of an asset I Rf = risk-free rate of return, commonly measured by return on treasury bills or government securities 1 = beta coefficient or index of non diversifiable risk for the asset I Km = market rate of return on the market portfolio of assets LOVELY PROFESSIONAL UNIVERSITY 79

86 Financial Management The CAPM can be divided into two parts (1) risk-free interest Rf which is required return on a risk free asset typically treasury bill or short-term government security and (2) the risk premium. These are respectively the two elements on the either side of the plus sign in the above equation. The (km Rf) portion of the risk premium is called the market risk premium, because it represents the premium the investor must receive for taking the average amount of risk associated with holding the market portfolio of assets. The risk premium is the highest for small company stocks, followed by large company stocks, long-term corporate bonds, and long-term government bonds. Small company stocks are riskier than large company stocks, which are riskier than long-term corporate bonds (equity is riskier than debt instrument). Long-term corporate bonds are riskier than long-term government bonds (because the government is less likely to ravage on debt). And of course, treasury bills and short-term government securities because of no default risk, very short maturity virtually risk-free as indicated by zero risk premium. Other things being equal, the higher the beta, the higher the required return and lower the beta, the lower the required return. Example: B Co. Ltd., wishes to determine the required rate of return on an asset Z, which has a beta of 1.5. The risk free rate of return is 7%, the return on market portfolio of assets is 11%. Thus we get: Kz = 7% (11% 7%) = 7% + 6% = 13% The market risk premium 4% (11% 7%) when adjusted for the assets index of risk (beta) of 1.5, results in a risk premium of 6% (1.5 4%). That risk premium when added to 7% risk-free return, results in 13% required return Assumptions of CAPM 1. Market efficiency: The capital markets are efficient. The capital market efficiency implies that share prices reflect all available information. 2. Risk aversion: Investors are risk-averse. They evaluate a security s return and risk in terms of the expected return and variance or standard deviation respectively. They prefer the highest expected return for a given level of risk. 3. Homogenous expectations: All the investors have the same explanation about the expected return and risk of securities. 4. Single time period: All investors can lend or borrow at risk-free rate of interest. 5. Risk-free rate: All investors can lend or borrow at a risk-free rate of interest Interpreting Beta The beta of a portfolio can be easily estimated by using the betas of the individual assets it includes. Suppose w 1, represent the proportion of the portfolio s total rupee value represented by asset j, and let, denotes beta of the asset, the portfolio beta p = (w 1 1 ) + (w 2 2 ) +.. ( ) n wn = w i= 1 å n 1 1 of course n å = I which means that 100 per cent of the portfolio s assets must be i= 1 included in the computation. 80 LOVELY PROFESSIONAL UNIVERSITY

87 Unit 5: Risk and Return Analysis Portfolio betas are interpreted in the same way as the betas of individual assets. They indicate the degree of responsiveness of the portfolio s return to changes in the market return. For example, when the market return increases by 10 per cent, a portfolio with a beta of 0.75 will experience a 7.5 per cent increase in its return ( %). Again since beta measures the relative volatility of a security s return, in relation to the market return, it should be measured in terms of security s and markets covariance and markets variance. Thus 1 can be measured by: 1 = Cov(K, K ) s s Cor j s Cor j = = 2 2 s s m sm i m 1 m m 1 m Where, k i = The expected return on indiversifiable security K m s 1 s m Cov (kikm) Cor jm = The expected return on market portfolio = Standard deviation of the security = Standard deviation of the market portfolio = Covariance of security with regard to market portfolio = Correlation coefficient of the security with the market Example: An investor is seeking the price to pay for a security whose standard deviation is 3.00 per cent. The correlation coefficient for the security with the market is 0.8 and the market standard deviation is 2.2 per cent. The return for government securities is 7.2 per cent and from the market portfolio 12.8 per cent. The investors know that, by calculating the required return he can determine the price to pay for the security. What is the required return on the security? Solution: Beta Coefficient = = Required rate of return = ( ) = = Task An investor holds two equity shares X and Y in equal proportion with the following risks and return characteristics: Return of Security X = 24 %; Return of Security Y = 19 % Standard Deviation of X = 28% Standard Deviation of Y = 23 % The return of these securities has a positive correlation of 0.6. You are required to calculate the portfolio return and risk. Further suppose that the investor wants to reduce the portfolio risk to 15 per cent. How much should the correlative coefficient be to bring the particular risk to the desired level? Limitations of CAPM 1. It is based on unrealistic assumptions that are far from reality. For example, it is very difficult to find a risk-free security, since inflation causes uncertainty about the real rate of return. The assumption of the equality of lending and borrowing rate is also not correct. Further, investors may not hold highly diversified portfolio or the market indices may not be well-diversified. LOVELY PROFESSIONAL UNIVERSITY 81

88 Financial Management 2. It is difficult to test the validity of CAPM from a practical point of view. 3. Betas do not remain stable over time. Beta is a measure of a security s future risk. But investors do not have future data to estimate beta. What they have are past data about the share prices and market portfolio. Thus, they can only estimate beta based on historical data. This implies that historical betas are poor indicators of the future risk of securities.! Caution Investors can use historical data as the measure of future risk only if it is a stable over time. Despite the limitations of CAPM, it provides a useful conceptual framework for evaluating and linking risk and return. An awareness of the trade-off and an attempt to consider risk as well as return in financial decision-making should help financial managers achieve their goals. Self Assessment Fill in the blanks: 13. is a measure of a security s risk relative to the market portfolio. 14. The CAPM can be divided into two parts which are risk-free interest and the provides a framework for measuring the systematic risk of an individual security and relates it to the systematic risk of a well diversified portfolio. Case Study Case: To Invest or Not? Wipro Company has asked the investors to invest in their securities & while making an offer, they have provided you with the following information. For a period of 10 years, company has provided you with the rate of return on security & return on the market portfolio of its securities as: Period Return on security WIPRO (%) Return on market portfolio (%) You as an investor have decided to invest in the securities of the company. The anticipated return with the associated probabilities is as: Contd LOVELY PROFESSIONAL UNIVERSITY

89 Unit 5: Risk and Return Analysis Return % Probability Question Now after getting all the details, what would you suggest, whether to invest in the securities or not and what would be your expected rate of return & risk in terms of standard deviation. Also give your comments based on the average rate of return, variance and beta value for the company s securities. 5.6 Summary Risk is the chance of financial loss. Some risks directly affect both finance managers and the shareholders whereas some risks are from specific and some are shareholders specific. Sensitivity analysis and probability distribution can be used to assess the general level of risk associated with a single asset. Probability distribution provides a more quantitative insight into an assets risk. The risk of asset in addition to range can be measured quantitatively by using statistical methods the standard deviation and the co-efficient of variation. The coefficient of variation (CV) is a measure of relative dispension that is useful in comparing the risk of assets with differing expected returns The risk of a portfolio can be measured in terms of variance or standard deviation. The correlation coefficient will always be between +1 and 1. The part of the risk that can be totally reduced through diversification is called unsystematic risk and the part of the risk that cannot be reduced through diversification is called systematic risk. Capital Asset Pricing Model (CAPM) provides a framework for measuring the systematic risk of an individual security and relates it to the systematic risk of a well diversified portfolio. 5.7 Keywords Beta: It is a measure of the systematic risk of a security that cannot be avoided through diversification. Correlation: It is a statistical measure that indicates the relationship between series of number representing anything from cash flows to test data. Covariance: It is the measure of their co-movement, expressing the degree to which the securities vary together. Non-systematic Risk: The variability in a security is total returns not related to overall market variability. Portfolio: It is a collection of securities Risk: Probability that the expected return from the security will not materialize. Systematic Risk: Variability in a security is total returns that are directly associated with overall movements in the general market or economy is called systematic risk. LOVELY PROFESSIONAL UNIVERSITY 83

90 Financial Management 5.8 Review Questions 1. Explain how the range is used in sensitivity analysis? 2. What relationship exists between the size of the standard deviation and the degree of asset risk? 3. When is coefficient of variation preferred over the standard deviation for comparing asset risk? 4. What is an efficient portfolio? How can the return and standard deviation of a portfolio be determined? 5. Why is the correlation between asset returns important? How does diversification allow risky assets to be combined so that the risk of the portfolio is less than the risk of the individual assets in it? 6. What risk does beta measure? How can you find the beta of a portfolio? 7. Explain the meaning of each variable in the capital asset pricing model (CAPM) equation. 8. Why do financial managers have some difficulty applying CAPM in financial decisionmaking? Generally, what benefits does CAPM provide them? 9. J Co. has the following dividend per share and the market price per share for the period 1997 to Year Dividend Market Price ( ) Calculate the annual rates of return for last 5 years. How risky is the share? 10. The shares of H.Co.Ltd. has the following anticipated return with associated probabilities. Return % Probability Calculate the expected rate of return and the risk factor. 84 LOVELY PROFESSIONAL UNIVERSITY

91 Unit 5: Risk and Return Analysis Answers: Self Assessment 1. financial 2. Return 3. risk indifferent 4. probability distribution 5. probability distribution 6. coefficient of variation 7. weightage average 8. optimal 9. variance 10. correlation 11. systematic 12. correlation coefficient 13. Beta 14. risk premium 15. CAPM 5.9 Further Readings Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2. Chandra, P., Financial Management Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p. 3. LOVELY PROFESSIONAL UNIVERSITY 85

92 Financial Management Unit 6: Cost of Capital CONTENTS Objectives Introduction 6.1 Cost of Capital Concept 6.2 Importance/Significance of Cost of Capital 6.3 Classification of Cost 6.4 Computation of Specific Cost of Capital Cost of Equity Cost of Preference Shares Cost of Debentures/Debt/Public Deposits 6.5 Weighted Average Cost of Capital (Wacc) Steps Involved in Computation of WACC Marginal Cost of Capital Factors Affecting Wacc 6.6 Summary 6.7 Keywords 6.8 Review Questions 6.9 Further Readings Objectives After studying this unit, you will be able to: Recognize the significance of cost of capital Discuss the basic aspects of the concept of cost of capital Categorize the costs Identify the factors that affect cost of capital Introduction The cost of capital is an important concept in formulating a firm s capital structure. Cost of capital is a central concept in financial management. It is also viewed as one of the corner stones in the theory of financial management. It has received considerable attention from both theorists and practitioners. Two major schools of thought, have emerged having basic difference on the relevance of cost of capital. In one camp, Modigliani Miller argued, that a firm s cost of capital is constant and it is independent of the method and level of financing. In another camp (traditionalists) cost of capital is varying and dependent on capital structure. In both the camps, optimal policy is taken as the policy that maximizes the value of a company. 86 LOVELY PROFESSIONAL UNIVERSITY

93 Unit 6: Cost of Capital Cost of capital is still largely an academic term and the problem of measuring it in operational terms is a recent phenomena. Prior to this development, the problem was either ignored or by passed. In modern times, it is widely used as basis of investment projects and evaluating the alternative sources of finance. 6.1 Cost of Capital Concept The term cost of capital is a concept having many different meanings. The three viewpoints, regarding the cost of capital is given below: 1. From Investors View Point: Investor may define it as the measurement of the sacrifice made by him in capital formation. Example: Mr. A an investor invested in a company s equity shares, amount 1,00,000, instead of investing in a bank at the rate of 7 per cent interest. Here he had sacrificed 7 per cent interest for not having invested in the bank. 2. Firms Point: It is the minimum required rate of return needed to justify the use of capital. Example: A firm raised 50 lakhs through the issues of 10 per cent debentures, for justifying this issue, a minimum rate of return it has to earn is 10 per cent. 3. Capital Expenditure Point: The cost of capital is the minimum required rate of return, the hurdle or target rate or the cut off rate or any discounting rate used to value cash flows. Example: Firm A is planning to invest in a project, that requires 20 lakh as initial investment and provides cash flows for a period of 5 years. So for the conversion of future 5 years cash flows into present value, cost of capital is needed. Cost of capital represents the rate of return that the firm must pay to the fund suppliers, who have provided the capital. In other words, cost of capital is the weighted average cost of various sources of finance used by the firm. The sources are, equity, preference, long-term debt and short-term debt. The rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due. Hunt, William and Donaldson Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditures. Solomon Ezra A cut-off rate for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock. James C. Van Horne The rate of return the firm requires, from investment in order to increase the value of the firm in the market place. Hampton, John J Thus, as defined above, we can say, that cost of capital is that minimum rate of return, which a firm must and is expected to earn on its investments so as to maintain the market value of its shares. It is also known as Weighted Average Cost of Capital (WACC), composite cost of capital or combined cost of capital. It is expressed in terms of percentage. LOVELY PROFESSIONAL UNIVERSITY 87

94 Financial Management Basic Aspects on the Concept of Cost of Capital The above definitions indicates, that the following are the three basic aspects of the concept of cost of capital: 1. Rate of Return: Cost of capital is not a cost as such, infact it is the rate of return that a firm requires to earn from its investment projects. 2. Minimum Rate of Return: Cost of capital of any firm is that minimum rate of return that will at least maintain the market value of the shares. 3. Cost of capital comprises three components: (a) The risk less cost of the particular type of financing (r j ) (b) (c) The business risk premium, (b) and The financial risk premium (f) Symbolically cost of capital may be represented as: K o = r j + b + f Self Assessment Fill in the blanks: 1. Cost of capital represents the that the firm must pay to the fund suppliers, who have provided the capital. 2. Cost of capital is expressed in terms of. 3. Investor defines Cost of capital as the measurement of the sacrifice made by him in Importance/Significance of Cost of Capital The concept of cost of capital is very important and the central concept in financial management decisions. The decisions in which it is useful are as follows: 1. Designing Optimal Corporate Capital Structure: This concept is helpful in formulating a sound and economical capital structure for a firm. The debt policy of a firm is significantly influenced by the cost consideration. Capital structure involves determination of proportion of debt and equity in capital structure that provides less cost of capital.! Caution While designing a firm s capital structure, the financial executives always keep in mind minimisation of the over all cost of capital and to maximise value of the firm. The measurement of specific costs of each source of funds and calculation of weighted average cost of capital help to form a balanced capital structure. By comparing various (sources of finance) specific costs, he/she can choose the best and most economical source of finance and can succeed in designing a sound and viable capital structure. 2. Investment Evaluation/Capital Budgeting: Wilson R.M.S., states that the Cost of Capital is a concept, which should be expressed in quantitative terms, if it is to be useful as a cutoff rate for capital expenses. Capital expenditure means investment in long-term projects like investment on new machinery. It is also known as Capital budgeting expenditure. Capital budgeting decisions require a financial standard (cost of capita) for evaluation. The financial standard is Cost of Capital. In the Net Present Value (NPV) method, an investment project is accepted, if the present value of cash inflows are greater than the 88 LOVELY PROFESSIONAL UNIVERSITY

95 Unit 6: Cost of Capital present value of cash outflow. The present values of cash inflows are calculated by discounting the rate known as Cost of Capital. If a firm adopts Internal Rate of Return (IRR) as the technique for capital budgeting evaluation, investment should be accepted only when cost of capital is less than the calculated IRR. Hence, the concept of cost of capital is very much useful in capital budgeting decisions, particularly if a firm is adopting discounted cash flow methods of project evaluation. 3. Financial Performance Appraisal: Cost of capital framework can be used to evaluate the financial performance of top management. Financial performance evaluation involves a comparison of actual profitability of the investment project with the project overall cost of capital of funds raised to finance the project. If the actual profitability is more than the projected cost of capital, then the financial performance may said to be satisfactory and vice versa. The above discussion clearly shows the role of cost of capital in financial management decisions. Apart from the above areas (decisions), cost of capital is also useful in (distribution of profits), capitalization of profits, making to rights issue and investment in owner assets. Self Assessment Fill in the blanks: 4. The.policy of a firm is significantly influenced by the cost consideration. 5. In the Net Present Value (NPV) method, the present values of cash inflows are calculated by discounting the rate known as. 6. If the is more than the projected cost of capital, then the financial performance may said to be satisfactory. 6.3 Classification of Cost Figure 6.1: Classification of Cost Classification of cost Marginal cost of capital Average cost Historic cost Future cost Specific cost Spot cost Opportunity cost Explicit cost Before going to discuss the computation of specific cost of each source of funds and cost of capital, it is wise to know various relevant costs associated with the problem of measurement of cost of capital. The relevance costs are: 1. Marginal Cost of Capital: A marginal cost is the additional cost incurred to obtain additional funds required by a firm. It refers to the change in the total cost of capital resulting from the use of additional funds. The marginal cost of capital is a very important concept in investment decisions (capital budgeting decisions). 2. Average Cost/Composite/Overall Cost: It is the average of various specific costs of the different components of equity, preference shares, debentures, retained earnings of capital LOVELY PROFESSIONAL UNIVERSITY 89

96 Financial Management structure at a given time and this is used as the acceptance criteria for (capital budgeting) investment proposals. 3. Historic Cost/Book Cost: The book cost has its origin in the accounting system in which book values, as maintained by the books of accounts, are readily available. They are related to the past. It is in common use for computation of cost of capital. For example, cost of capital may be computed based on the book value of the components of capital structure. Did u know? Historical costs act as guide for future cost estimation. 4. Future Cost: It is the cost of capital that is expected to raise funds to finance a capital budget or investment proposal. 5. Specific Cost: It is the cost associated with particular component/source of capital. It is also known as component cost of capital. For example, cost of equity (Ke) or cost of preference share (Kp), or cost of debt (Kd), etc. 6. Spot Cost: The costs that are prevailing in the market at a certain time. For example, few years back cost of bank loans (house loans) was around 12 per cent, now it is 6 per cent is the spot cost. 7. Opportunity Cost: The opportunity cost is the benefit that the shareholder foregoes by not putting his/her funds elsewhere because they have been retained by the management. For example, an investor, had invested in a company s equity shares (100 shares, each share at 10). The company decided to declare dividend of 10 per cent on book value of share, but due to capital requirements it retains its investment on one project that is having return on investment (RoI) of 4 per cent. Elsewhere, the project rate of interest (banks) is at 6 per cent. Here, the opportunity cost to the investor is (6-4) 2 per cent. 8. Explicit Cost: Cost of capital can be either explicit or implicit. Distinction between explicit and implicit is important from the point of view of computation cost of capital. An explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows, that are incremental to the taking of the financing opportunity with present value of its increments cash outflows. In other words, the discount rate that equates the present value of cash inflows with present value of cash outflows. It is also called as the internal rate of return. For example, a firm raises 1,00,000 through the sale of 12 per cent perpetual debentures. There will be a cash inflow of 1,00,000 and a cash outflow of 12,000 every year for a indefinite period. The rate that equates the PV of cash inflows ( 1,00,000) and PV of cash outflows ( 12,000 per year) would be the explicit cost. Computation of explicit cost is almost similar to the computation of IRR, with one difference. 9. Implicit Cost: It is the cost of opportunity, which is given up in order to pursue a particular action. It is also known as implicit cost of capital. The implicit cost of capital of funds raised and invested by the firm may, therefore be defined as the rate of return associated with the best investment opportunity for the firm and its shareholders that would be foregone, if the projects presently under consideration by the firm were accepted. The cost of retained earnings is an opportunity cost of implicit cost for a shareholder, who is deprived of the opportunity to invest retained earnings elsewhere. Funds raised by any form of financing have implicit capital costs once they are invested. Thus, in a sense, implicit costs may also be viewed as opportunity costs. This implies that a project reflects negative PV, when its cash flows are discounted by the implicit cost of capital. 90 LOVELY PROFESSIONAL UNIVERSITY

97 Unit 6: Cost of Capital Self Assessment Fill in the blanks: 7. A cost is the additional cost incurred to obtain additional funds required by a firm. 8..is the cost of capital that is expected to raise funds to finance a capital budget or investment proposal. 9...Cost is the cost that is prevailing in the market at a certain time. 6.4 Computation of Specific Cost of Capital The financial manager has to compute the specific cost of each type of funds needed in the capitalisation of a company. The company may resort to different financial sources (equity share, preference share, debentures, retained earning public deposits; or it may prefer internal source (retained earnings) or external source (equity, preference and public deposits). Generally, the component cost of a specific source of capital is equal to the investors required rate of returns. Investors required rate of returns are interest, discount on debt, dividend, capital appreciation, earnings per share on equity shareholders, dividend and share of profit on preference shareholders funds. But investors required rate of returns should be adjusted for taxes in practice for calculating the cost of a specific source of capital, to the firm. Compensation of specific source of finance, viz., equity, preference shares, debentures, retained earnings, public deposits is discussed below: Cost of Equity Firms may obtain equity capital in two ways (a) retention of earnings and (b) issue of additional equity shares to the public. The cost of equity or the returns required by the equity shareholders is the same in both the cases, since in both cases, the shareholders are providing funds to the firm to finance their investment proposals. Retention of earnings involves an opportunity cost. The shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings or issue of additional equity shares, the cost of equity is same. But issue of additional equity shares to the public involves a floatation cost whereas, there is no floatation cost for retained earnings. Hence, issue of additional equity shares to the public for raising equity finance involves a bigger cost when compared to the retained earnings. In the following cost of equity is computed in both sources point of view (i.e., retained earnings and issue of equity shares to the public). Cost of Retained Earnings (K re ) Retained earnings is one of the internal sources to raise equity finance. Retained earnings are those part of (amount) earnings that are retained by the form of investing in capital budgeting proposals instead of paying them as dividends to shareholders. Corporate executives and some analysts too normally consider retained earnings as cost free, because there is nothing legally binding the firm to pay dividends to equity shareholders and the company has its own entity different from its stockholders. But it is not so. They involve opportunity cost. The opportunity cost of retained earning is the rate of return the shareholder forgoes by not putting his/her funds elsewhere, because the management has retained the funds. The opportunity cost can be well computed with the following formula. æ (1 - T ) ö i Kre = Ke ç 100 è (1 - T b ) ø LOVELY PROFESSIONAL UNIVERSITY 91

98 Financial Management Where, K e T i T b = Cost of equity capital [D P or E/P + g]. = Marginal tax rate applicable to the individuals concerned. = Cost of purchase of new securities/broker. Illustration 1: D = Expected dividend per share. NP = Net proceeds of equity share/market price. g = Growth rate in (%). A company paid a dividend of 2 per share, market price per share is 20, income tax rate is 60 per cent and brokerage is expected to be 2 per cent. Compute the cost of retained earnings. Solution: K re = = ( 1 Ti ) ( 1 T ) æ D ö ç 100 NP è ø b ( ) ( ) æ 2 ö ç 100 è ø = = 4.1 per cent Illustration 2: ABC company s cost of equity (Ke) capital is 14 per cent, the average tax rate of individual shareholders is 40 per cent and it is expected that 2 per cent is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings? Solution: K re = = ( 1 Ti ) ( 1 T ) æ ö K 100 ç e è b ø ( 1-0.4) ( ) = ( ) 100 = 8.6 per cent Illustration 3: Life Style Garment Manufacturing Company has net earnings of 20 lakhs and all of its stockholders are in the bracket of 50 per cent. The management estimates that under the present conditions, the stockholder s required rate of returns is 12 per cent. 3 per cent is the expected brokerage to be paid if stockholders want to invest in alternative securities. Compute the cost of retained earnings. Solution: K re = ( 1 Ti ) ( 1 T ) æ ö Ke ç 100 è ø b 92 LOVELY PROFESSIONAL UNIVERSITY

99 Unit 6: Cost of Capital = = ( ) 100 = 5.2 per cent Illustration 4: BPL company s equity share is currently being sold at and it is currently paying a dividend of 5.25 per share. The dividend is expected to grow at 15 per cent per annum for one year. Income tax rate is 40 per cent and brokerage is 2 per cent. Calculate cost of retained earnings. Solution: K re = = NP 1 T D + g i T b Cost of Issue of Equity Shares (K e ) = ( ) 100 = 10.2 per cent Calculation of cost of equity (K e ) capital cost brings forth, a host of problems. It is the most difficult and controversial cost to measure because there is no one common basis for computation. For calculation of cost of debt (K d ) interest charge is the base and preference dividend is the base for calculation of cost of preference shares (K p ). Interest on debentures/debt and dividend on preference shares is fixed in terms of the stipulations following the issue of such debentures and shares. In contrast, the return on equity shareholders solely depends upon the discretion of the company management. Apart from this, there is no stipulation for payment of dividend to equity shareholders. They are ranked at the bottom as claimants on the assets of the company at the time of liquidation. Though it is quite evident from the above discussion that, equity capital does not carry any cost. However, this is not true, equity capital has some cost. The cost of equity capital (K e ), may be defined as the minimum rate of returns that a firm must earn on the equity financed portions of an investment project in order to leave unchanged the market price of the shares. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed rate every year. Approaches to Calculate the Cost of Equity (K e ) There are six approaches available to calculate the cost of equity capital, they are: Dividends Capitalisation Approach (D/MN Approach) According to this approach, the cost of equity capital is calculated on the basis of a required rate of return in terms of the future dividends to be paid on the shares. Accordingly, K e is defined as the discount rate that equates the present value of all expected future dividends per share, along with the net proceeds of the sale (or the current market price) of a share. It means investor arrives at a market price for a share by capitalizing dividends at a normal rate of return. The cost of equity capital can be measured by the given formula: K e = D/CMP or NP LOVELY PROFESSIONAL UNIVERSITY 93

100 Financial Management Where, K e = Cost of equity D = Dividends per share CMP = Current market price per share NP = Net proceed per share This method assumes that investor give prime importance to dividends and risk in the firm remains unchanged and it does not consider the growth in dividend. Illustration 5: XYZ Ltd., is currently earning 1,00,000, its current share market price of 100 outstanding equity shares is 10,000. The company decides to raise an additional capital of 2,50,000 through issue of equity shares to the public. It is expected to pay 10 per cent per share as floatation cost. Equity capital is issued at a discount rate of 10 per cent, per share. The company is interested to pay a dividend of 8 per share. Calculate the cost of equity. Solution: K e = D 100 NP K = e K e = = 10 per cent Dividend capitalization approach, suffers from the following limitations: 1. It does not consider future earnings. 2. It ignores the earnings on retained earnings. 3. It ignores the fact that market price raise may be due to retained earnings and not on account of high dividends. 4. It does not take into account the capital gains. Earnings Capitalisation Approach (E/MP Approach) According to this approach, the cost of equity (K e ) is the discount rate that equates the present value of expected future earnings per share with the net proceeds (or current market price) of a share. The advocates of this approach establish a relationship between earnings and market price of the share. They say that, it is more useful than the dividend capitalisation approach, due to two reasons, one, the earnings capitalization approach acknowledges that all earnings of the company, after payment of fixed dividend to preference shareholders, legally belong to equity shareholders whether they are paid as dividends or retained for investment, secondly, and most importantly, determining the market price of equity shares is based on earnings and not dividends. Computation 94 LOVELY PROFESSIONAL UNIVERSITY

101 Unit 6: Cost of Capital of retained earnings cost, taken separately leads to double the company s cost of capital. Assumption of earnings capitalization approach is employed under the following conditions: 1. Constant earnings per share over the future period; 2. There should be either 100 per cent rotation ratio or 100 per cent dividend payout ratio; and 3. The company satisfies the requirements through equity shares and does not employ debt. Cost of equity can be calculated with the following formula: K e = E CMP or NP Where, Illustration 6: K e = Cost of equity E = Earnings per share CMP = Current market price per share NP = Net proceeds per share. Well do Company Ltd. is currently earning 15 per cent operating profit on its share capital of 20 lakh (FV of 200 per share). It is interested to go for expansion for which the company requires an additional share capital of 10 lakh. Company is raising this amount by the issue of equity shares at 10 per cent premium and the expected floatation cost is 5 per cent. Calculate the cost of equity. Solution: K e = E 100 NP 30 = = Calculation of EPS = 14.3 per cent Operating Profit = 20,00, = 3,00,000 No.of Equity Shares = 20,00,000/200 = 10,000 Shares EPS = 3,00,000/10,000 = Net Proceeds (NP) = Face value + Premium Floatation cost = = 210 Illustration 7: A firm is currently earning 1,00,000 and its share is selling at a market price of 90. The firm has 10,000 shares outstanding and has no debt. Compute the cost of equity. Solution: K e = E 100 MP LOVELY PROFESSIONAL UNIVERSITY 95

102 Financial Management = = Limitations: Earnings capitalization approach has the following limitations: 1. All earnings are not distributed to the equity shareholders as dividends. 2. Earning per share may not be constant. 3. Share price also does not remain constant. Dividend Capitalization plus Growth Rate Approach [(D/MP) + g] Computation of cost of equity capital based on a fixed dividend rate may not be appropriate, because the future dividend may grow. The growth in dividends may be constant perpetually or may vary over a period of time. It is the best method over dividend capitalisation approach, since it considers the growth in dividends. Generally, investors invest in equity shares on the basis of the expected future dividends rather than on current dividends. They expect increase in future dividends. Growth in dividends will have positive impact on share prices. Cost of Capital under Constant Growth Rate Perpetually: The formula for computation of cost of equity under constant growth rate is: Where, K e = K e D +g NP or CMP = Cost of equity capital D = Dividends per share. NP = Net proceeds per share. CMP = Current market price per share. g = Growth rate (%). Illustration 8: Equity shares of a paper manufacturing company is currently selling for 100. It wants to finance its capital expenditure of 1 lakh either by retaining earnings or selling new shares. If company seeks to sell shares, the issue price will be 95. The expected dividend next year is 4.75 and it is expected to grow at 6 per cent perpetually. Calculate cost of equity capital (internal and external). Solution: K e = D +g MP K e = = = 10.8 per cent Calculate cost of external equity (Issue of shares) K e = = = 11 per cent 96 LOVELY PROFESSIONAL UNIVERSITY

103 Unit 6: Cost of Capital Cost of Capital under Variable Growth Rate: The computation cost of equity after a specific period, is based on the estimation of growth rate in dividends of a company. Expected growth rate will be calculated based upon the past trend in dividend. It may not be unreasonable to project the trend into the future, based on the past trend. The financial manager must estimate the internal growth rate in dividends on the basis of long range plans of the company. Expected growth rate in the internal context requires to be adjusted. Compound growth rate in dividends can be computed with the following formula. gr = D o (1 + r) n = D n Where, gr = Growth rate in dividends D o = First year dividend payment (1 + r) n = Present value factor for nth year D n = Last year dividend payment. Illustration 9: From the following dividends record of a company, compute the expected growth rate in dividends. Solution: Year Dividends per share ( ) gr = D o (1 + r) n = D n = 21 (1 + r) 7 = 28 (1 + r) 7 = (1 + r) 7 = During seven years the dividends has increased by 7 giving a compound factor of The growth rate is 4 per cent since the sum of 1 would accumulate to in seven years at 4 per cent interest. Illustration 10: Mr. A an investor, purchases an equity share of a growing company for 210. He expects the company to pay dividends of 10.5, and in years 1, 2 and 3 respectively and he expects to sell the shares at a price of at the end of three years. 1. Determine the growth rate in dividends. 2. Calculate the current dividend yield. 3. What is the required rate of return of Mr. A on his equity investment? Solution: 1. Computation of growth rate (gr) gr = D o (1 + r) n = D n = 10.5 (1 + r) 2 = (1 + r) 2 = (1 + r) 2 = gr = 5 per cent LOVELY PROFESSIONAL UNIVERSITY 97

104 Financial Management 2. Calculation of the current dividend yield 3rd year dividend Current dividend yield = = Growth in dividend is [ ] = Current dividend yield = 5 per cent In simple words, current dividend yield is equal to growth rate in dividends. 3. Mr. A s required rate of return K e = D +g Expected sales price (MP) = Illustration 11: (Variable growth rates) = = = 10 per cent A textile company s dividends have been expected to grow in the following manner. 1 2 years 15 per cent 3 5 years 10 per cent 6 year and beyond 5 per cent The company currently pays a dividend of 2 per share, which is currently selling at 75 per share. What would be the cost of equity capital assuming a fixed dividend pay out ratio? Solution: NP = t n D0 1+gr Dn+1 1 t + n n 1+ K K - g 1+ K t=1 e e e ( ) 1 75 = K 1+ K 1+ K 1+ K 1+ K 1+ K 1+ K e e e e e e e 2.3 PVIF PVIF PVIF PVIF + = 1.K e 2.Ke 3.Ke 4.Ke By trial and error method using PV tables, we find Ke = 14% First trial at 14% PVIF 3.52 PVIF 5.K + e K = 2.3(0.877)+2.645(0.769)+2.909(0.675)+3.2(0.592)+3.52(0.519)+ (0.456) = = 28.5 e 6.Ke 98 LOVELY PROFESSIONAL UNIVERSITY

105 Unit 6: Cost of Capital Here, 75 is not equal to 28.5, for increasing the 28.5 to 75 we have to try at a lower rate, say 6% = (0.943) (0.890) (0.840) + 3.2(0.823) (0.747) + (0.705) = = New PV of cash out flows exceeding cash inflow. So, we will use interpolation formula æ ö 6%+ ç 14% 6% è ø K e = ( ) = æ ö 6%+ 8% ç è ø K e = 6% = per cent. Bond Yield Plus Risk Premium Approach According to this approach, the rate of return required by the equity shareholder of a company is equal to K e = Yield on long-term bonds + Risk premium The logic of this approach is very simple, equity investors bear a higher risk than bond investors and hence their required rate of return should include a premium for their higher risk. In other words, bond holders and equity shareholders, both are providing funds to the company, but the company assures a fixed rate of interest to the bond holders and not to the equity shareholders, hence, there is a risk involved due to uncertainty of expected dividends. It makes a sense to base the cost of equity on a readily observable cost of debt. The problem involved in this approach, is the addition of premium, should it be one per cent, two per cent, three per cent or n per cent. There is no theoretical basis for estimating the risk premium. Most analysts look at the operating and financial risks of the business and arrive at a subjectively determined risk premium that normally ranges between 3 per cent to 5 per cent. Cost of equity capital calculated, based on this approach is not a precise one, but it is a ballpark estimation. Computation of the cost of equity based on dividends capitalisation and earnings capitalisation, have serious limitations. It is not possible to estimate future dividends and earnings correctly, both these variables are uncertain. In order to remove the difficulty in the estimation of the rate of return that investors expect on equities, where future dividends, earnings and market price of share are uncertain, Realised Yield Approach is suggested. Did u know? What is Realised Yield Approach? Realised Yield Approach takes into consideration that, the actual average rate of returns realised in the past few years, may be applied to compute the cost of equity share capital i.e, the average rate of returns realised by considering dividends received in the past few years along with the gain realised at the time of sale of share. This is more logical because the investor expects to receive in future at least what he has received in the past. The realised yield approach is based on the following assumptions: 1. Firms risk does not change over the period. 2. Past realised yield is the base for shareholders expectations. LOVELY PROFESSIONAL UNIVERSITY 99

106 Financial Management 3. There is no opportunity cost to investors. 4. Market price of equity share does not change significantly. Calculation of the cost of equity based on realised yield approach is not realistic, due to unrealistic assumptions. Illustration 12: XYZ Company is planning to sell equity shares. Mr. A is planning to invest in XYZ Company by purchasing equity shares. Bond yield of XYZ Company is 12 per cent. Mr. A, an investor requests you to calculate his required rate of return on equity with 3 per cent risk premium. Solution: Illustration 13: K e = Bond yield + Risk premium = 10% + 3% = 13 per cent An investor purchased equity share of HPH company at 240 on and after holding it for 5 years sold the share in early 2003 at 300. During this period of 5 years, he received a dividend of 14 in 1998 and 1999 and 14.5 from 2000 to Calculate the cost of equity capital based on realised yield approach with 10 per cent discounting factor. Solution: Years Cash inflows ( ) DF 10% PV of Cash inflows ( ) (-) Purchase price in At 10 per cent discount rate, the total PV of cash inflows equals to the PV of cash outflows. Hence, cost of equity capital is 10 per cent Cost of Preference Shares The preference share is issued by companies to raise funds from investors. Preference share has two preferential rights over equity shares, (i) preference in payment of dividend, from distributable profits, (ii) preference in the payment of capital at the time of liquidation of the company. Computation of cost of preference share capital have some conceptual difficulty. Payment of dividend is not legally binding on the company and even if dividends are paid, they are not a charge on earnings, they are distributed from distributable profits. This may create an idea that preference share capital is cost free, which is not true. The cost of preference share capital is a function of the dividend expected by the investors. Generally, preference share capital is issued with an intention (a fixed rate) to pay dividends. In case dividends are not paid, it will affect the firm s fund raising capacity. For this reason, dividends on preference share capital should be paid regularly except when the firm does not make profits LOVELY PROFESSIONAL UNIVERSITY

107 Unit 6: Cost of Capital There are different types of preference shares, cumulative and non-cumulative, redeemable and irredeemable, participating and non-participating, and convertible and non-convertible. But computation of cost of preference share will be only for redeemable and irredeemable. Cost of Irredeemable Preference Share/Perpetual Preference Share The share that cannot be paid till the liquidation of the company is known as irredeemable preference share. The cost is measured by the following formula: K p (without tax) = D CMP or NP Where, K p = Cost of preference share D = Dividend per share CMP = Market price per share NP = Net proceeds Cost of irredeemable preference stock (with dividend tax) K p (with tax) = D( 1+D t ) CMP or NP Where, Illustration 14: D t = tax on preference dividend HHC Ltd., issues 12 per cent perpetual preference shares of face value of cost of preference share (without tax). 200 each. Compute Solution: K p = D 100 NP = 12 per cent Illustration 15: (with dividend tax) A company is planning to issue 14 per cent irredeemable preference share at the face value of 250 per share, with an estimated flotation cost of 5%. What is the cost of preference share with 10% dividend tax. Solution: K p = = D( 1+ D t ) 100 NP 35( ) 100 =16.21 per cent Illustration 16: Sai Ram & Co. is planning to issue 14 per cent perpetual preference shares, with face value of 100 each. Floatation costs are estimated at 4 per cent on sales price. Compute (a) cost of LOVELY PROFESSIONAL UNIVERSITY 101

108 Financial Management preference shares if they are issued at (i) face/par value, (ii) 10 per cent premium, and (iii) 5 per cent discount, (b) compute cost of preference share in these situation assuming 5 per cent dividend. Solution: Without dividend tax (i) Issued at face value 14 K p = =14.6 per cent (100-4) (ii) Issued at 10% premium 14 K p = =13.2 per cent (110-4) (iii) Issued at 5% discount 14 K p = =15.4 per cent ( ) With dividend tax (i) Issued at face value 14( ) K p = =15.4 per cent 96 (ii) Issued at 10% premium 14( ) K p = =13.9 per cent 106 (iii) Issued at 5% discount 14( ) K p = =16.2 per cent 91.2 Cost of Redeemable Preference Shares Shares that are issued for a specific maturity period or redeemable after a specific period are known as redeemable preference shares. The explicit cost of redeemable preference shares is the discount rate that equates the net proceeds of the sale of preference shares with the present value of the future dividend and principal repayments. In other words, cost of preference share is the discount rate that equates the present value of cash inflows (sale proceeds) with the present value of cash outflows (dividend + principal repayment). Dividends will be paid at the end of each year, but the principal amount will be repaid either in lump sum at the end of maturity period or in installments (equal or unequal). If the principal amount is paid in instalments, then the cash outflow for each year equals to dividend plus part of principal amount. Cost of preference shares, when the principal amount is repaid in one lump sum amount: NP = n å t=1 D t + P t ( 1+Kp) ( 1+Kp) n n D D D P n NP = ( 1+ K p ) ( 1+ K p ) ( 1+ K p ) ( 1+ K p ) n Where, K p = Cost of preference share. NP = Net sales proceeds (after discount, flotation cost). D = Dividend on preference share. P n = Repayment of principal amount at the end of n years. Illustration 17: (Lump sum repayment) A company issues 1,00,000, 10 per cent preference shares of 100 each redeemable after 10 years at face value. Cost of issue is 10 per cent. Calculate the cost of preference share. Solution: NP = n å t=1 D t + P t ( 1+Kp) ( 1+Kp) n n 102 LOVELY PROFESSIONAL UNIVERSITY

109 Unit 6: Cost of Capital 90 = 10 t= Kp 1+ Kp t 10 The trial and error method is used here, for the computation of the cost of preference share. Year Cash outflow ( ) PV factor Present Values 10% 12% 10% 12% Total PV of Cash outflow (-) PV of Cash inflow (-) 1.3 In trials, PV of cash outflow did not equal to the PV of cash inflow ( 100). Hence, cost of preference share is calculated by using interpolation formula. Where, LDFPV PV of CIF LDF(%)+ HDF- LDF LDFPV HDFPV K = LDF = Lower discounting factor in %. LDFPV = Lower discounting factor present value ( ). HDFPV = Higher discounting factor present value ( ). PV of CIF = Present value of cash inflows % + 12% - 10% Kp = = % Short cut formula: = 10% = 10% = per cent K p = D + (f + d + p r p i )/Nm (RV + NP)/2 Where, D = Dividend per share. f = Flotation cost ( ). d = Discount on issue of preference share ( ). p r = Premium on redemption of preference shares ( ). p i = Premium on issue of preference share ( ). N m = Term of preference shares. RV = Redeemable value of preference share. LOVELY PROFESSIONAL UNIVERSITY 103

110 Financial Management NP = Net proceeds realized. K p = 10 +( )/10 (100+90)/2 = 10 +(1) = per cent Cost of Debentures/Debt/Public Deposits Companies may raise debt capital through issue of debentures or loan from financial institutions or deposits from public. All these resources involve a specific rate of interest. The interest paid on these sources of funds is a charge on the profit & loss account of the company. In other words, interest payments made by the firm on debt issue qualify tax deduction in determining net taxable income. Computation of cost of debenture or debt is relatively easy, because the interest rate that is payable on debt is fixed by the agreement between the firm and the creditors. Computation of cost of debenture or debt capital depends on their nature. The debt/debentures can be perpetual or irredeemable and redeemable cost of debt capital is equal to the interest paid on that debt, but from company s point of view it will be less than the interest payable, when the debt is issued at par, since the interest is tax deductible. Hence, computation of debt is always after tax cost. Cost of Irredeemable Debt/Perpetual Debt Perpetual debt provides permanent funds to the firm, because the funds will remain in the firm till liquidation. Computation of cost of perpetual debt is conceptually relatively easy. Cost of perpetual debt is the rate of return that lender expect (i.e., fixed interest rate). The coupon rate or the market yield on debt can be said to represent an approximation of cost of debt. Bonds/ debentures can be issued at (i) par/face value, (ii) discount and (iii) premium. The following formulae are used to compute cost of debentures or debt of bond: (i) Pre-tax cost K di = I P or NP (ii) Post-tax cost K di = I(1 t) P or NP Where, K di = Pre-tax cost of debentures. I = Interest P = Principal amount or face value. P = Net sales proceeds. t = Tax rate. Illustration 18: XYZ Company Ltd., decides to float perpetual 12 per cent, debentures of 100 each. The tax rate is 50 per cent. Calculate cost of debenture (pre- and post-tax cost). 104 LOVELY PROFESSIONAL UNIVERSITY

111 Unit 6: Cost of Capital Solution: (i) Pre-tax cost K di = 12 = 12 per cent 100 (ii) Post-tax cost K d = = 6 per cent 100 Generally, cost of debenture is equal to the interest rate, when debenture is issued at par and without considering tax. Cost will be less than the interest when we calculate cost after considering tax since it is tax deductible. From the cost of capital point of view, debenture cost is always in post tax cost. Sometimes debentures may be issued at premium or discount. A company, which is having a good track record, will be issued at premium and a company that is new or unknown to the public or has a nominal or poor track record will be issued at discount. Whenever debentures are issued at premium or discount the cost of debenture will be affected, it will decrease or increase respectively. Illustration 19: Rama & Co. has 15 per cent irredeemable debentures of 100 each for 10,00,000. The tax rate is 35 per cent. Determine debenture assuming it is issued at (i) face value/par value (ii) 10 per cent premium and (iii) 10 per cent discount. Solution: Issued at Pre-tax Post-tax (i) Face value (ii) 10% premium (iii) 10% discount 15 = 15 per cent = 13.7 per cent ( ) = per cent (100 10) 90 ( ) = 9.8 per cent 100 ( ) = 8.9 per cent 110 ( ) = 10.9 per cent 90 Cost of Redeemable Debentures/Debt Redeemable debentures that, are having a maturity period or are repayable after a certain given period of time. In other words, these type of debentures that are under legal obligation to repay the principal amount to its holders either at certain agreed intervals during the duration of loan or as a lump sum amount at the end of its maturity period. These type of debentures are issued by many companies, when they require capital for fulfilling their temporary needs. LOVELY PROFESSIONAL UNIVERSITY 105

112 Financial Management Cost of Redeemable Debentures K d = n NI P t n t + 1+ K 1+ K t=1 d d n Where, K d = Cost of debentures. n = Maturity period. NI = Net interest (after tax adjustment). P n Illustration 20: = Principal repayment in the year n. BE Company issues 100 par value of debentures carrying 15 per cent interest. The debentures are repayable after 7 years at face value. The cost of issue is 3 per cent and tax rate is 45 per cent. Calculate the cost of debenture. Solution: Year Cash outflow ( ) t 1+ K 1+ K = + t=1 d d n DF PV of Cash Outflows ( ) 7% 10% 7% 10% PV of cash out flows (-) PV of Cash inflows Cost of debenture capital lies between 10 per cent and 12 per cent, because net present value 97 lies between the PV of 10 per cent and 12 per cent. Exact cost can be computed only with interpolation formula: Where, LDFPV NP LDF+ HDF- LDF LDFPV HDFPV K d = LDF = Lower discounting factor. HDF = Higher discounting factor. LDFPV = Lower discounting factor present value. HDFPV = Higher discounting factor PV. PVCIF = Present value of cash inflows NP = Net proceeds. K d = % = 7%+1.91 = 8.91% 106 LOVELY PROFESSIONAL UNIVERSITY

113 Unit 6: Cost of Capital Short cut method K p = RV+ NP /2 I 1 t + f+d+ p p /N r i m Where, I = Interest t = Tax rate f = Flotation cost d = Discount p r p i = Premium on redemption = Premium on issue RV = Redeemable value NP = Net proceed N m K p = = Maturity period of debt / /7 K p = 8.68 = 8.81% 98.5 Illustration 21: (Instalment repayment) Hari Ram & Co. issued 14 per cent debentures aggregate at 2,00,000. The face value of debenture is 100. Issue cost is 5 per cent. The company has agreed to repay the debenture in 5 equal instalment at par value. Instalment starts at the end of the year. The company s tax rate is 35 per cent. Compute cost of debenture. Solution: Years Sales proceeds = Face value Flotation cost = = 95 Instalment amount = Face value No. of instalments = = 20. Cash Outflow ( ) DF Factor PV of Cash Outflows ( ) (NI + Instalment) 8% 13% 8% 13% = = = = = PV of cash out flows PV of cash inflows % K d = (+) (-)3.770 = % = 8% = per cent LOVELY PROFESSIONAL UNIVERSITY 107

114 Financial Management Self Assessment Fill in the blanks: 10. Cost of debenture is equal to the., when debenture is issued at par and without considering tax. 11. Cost of preference share is the that equates the present value of cash inflows with the present value of cash outflows. 12. Retention of earnings involves an.cost. 6.5 Weighted Average Cost of Capital (WACC) A company has to employ a combination of creditors and fund owners. The composite cost of capital lies between the least and most expensive funds. This approach enables the maximisation of profits and the wealth of the equity shareholders by investing the funds in projects earning in excess of the overall cost o capital. The composite cost of capital implies an average of the costs of each of the source of funds employed by the firm property, weighted by the proportion they hold in the firm s capital structure Steps Involved in Computation of WACC 1. Determination of the type of funds to be raised and their individual share in the total capitalisation of the firm. 2. Computation of cost of specific source of funds. 3. Assignment of weight to specific costs. 4. Multiply the cost of each source by the appropriate assigned weights. 5. Dividing the total weighted cost by the total weights to get overall cost of capital. Once the company decides the funds that will be raised from different sources, then the computation of specific cost of each component or source is completed after which, the third step in computation of cost of capital is, assignment of weights to specific costs, or specific sources of funds. How to assign weights? Is there any base to assign weights? How many types of weights are there? Assignment of Weights: The weights to specific funds may be assigned, based on the following: 1. Book Values: Book value weights are based on the values found on the balance sheet. The weight applicable to a given source of fund is simply the book value of the source of fund divided by the book value of the total funds. The merits of book values weights are: (a) (b) (c) (d) Calculation of weights is simple. Book values provide a usable base, when firm is not listed or security is not actively traded. Book values are really available from the published records of the firm. Analysis of capital structure in terms of debt equity ratio is based on book value. Disadvantage of book value weights Book value proportions are not consistent with the concept of cost of capital because the latter is defined as the minimum rate of return to maintain the market value of the firm. 108 LOVELY PROFESSIONAL UNIVERSITY

115 Unit 6: Cost of Capital! Caution There is no relation between book values and present economic values of the various sources of capital 2. Capital Structure Weights: Under this method, weights are assigned to the components of capital structure based on the targeted capital structure. Depending up on the target, capital structures have some difficulties. They are: (a) (b) A company may not have a well defined target capital structure. It may be difficult to precisely estimate the components of capital costs, if the target capital is different from present capital structure. 3. Market Value Weights: Under this method, assigned weights to a particular component of capital structure is equal to the market value of the component of capital divided by the market value of all components of capital and capital employed by the firm. Advantages of Market Value Weights (a) (b) Market values of securities are approximately close to the actual amount to be received from their sale. Costs of the specific resources of funds that constitute the capital structure of the firm, are calculated by keeping in mind the prevailing market prices. Disadvantages of Market Value Weights (a) (b) (c) Market values may not be available when a firm is not listed or when the securities of the firm are very thinly traded. Market value may be distorted when securities prices are influenced by manipulation loading. Equity capital gets greater importance. Did u know? Most of the financial analysts prefer to use market value weights because it is theoretically consistent and sound. Illustration 22: A firm has the following capital structure as the latest statement shows: Source of Funds After Tax Cost (%) Debt Preference shares Equity share Retained earnings 30,00,000 10,00,000 20,00,000 40,00, Total 100,00,000 Based on the book values compute the cost of capital. Solution: Source of Finance Weights Specific Cost (%) Weighted Cost Debt Contd... LOVELY PROFESSIONAL UNIVERSITY 109

116 Financial Management Preference shares Equity share Retained earnings Overall cost of capital (Ko) = Total Weighted Cost 100 = = 8.2 per cent Cost of Weight Debt weight = Debt capital 30,00,000 = = 0.30 Total capital 1,00,00,000 Illustration 23: XYZ company supplied the following information and requested you to compute the cost of capital based on book values and market values. Source of Finance Book Value ( ) Market Value ( ) After Tax Cost (%) Equity capital 10,00,000 15,00, Long-term debt 8,00,000 7,50,000 7 Short-term debt 2,00,000 2,00,000 4 Total 20,00,000 24,50,000 Solution: Computation of Cost of Capital based on Book Value Source of Finance Book Value ( ) Weights Specific cost Weighted cost (1) (2) (3) (4) (5) = (3) (4) Equity capital 10,00, Long-term debt 8,00, Short-term debt 2,00, Total 20,00, Cost of capital = = 9.2 per cent Cost of Capital based on Market Value Weight Source of Finance Book Value ( ) Weights Specific cost Weighted cost (1) (2) (3) (4) (5) = (3) (4) Equity capital Long-term debt Short-term debt 15,00,000 7,50,000 2,00, ,50, Cost of capital = = 9.9 per cent 110 LOVELY PROFESSIONAL UNIVERSITY

117 Unit 6: Cost of Capital Weighted Average Cost of Capital (Alternative Method) Source of Finance Market Value ( ) Cost (%) Total Cost Equity capital Long-term debt Short-term debt (1) (2) (3) (4) = (2) (3) 15,00,000 7,50,000 2,00, ,80,000 52,500 8,000 24,50,000 2,40,500 WACC = = Total Cost Total Capital 2,40, = 9.9% approx. 10 per cent 24, 50, Marginal Cost of Capital Companies may rise additional funds for expansion. Here, a financial manager may be required to calculate the cost of additional funds to be raised. The cost of additional funds is called marginal cost of capital. For example, a firm at present has 1,00,00,000 capital with WACC of 12 per cent, but it plans to raise 5,00,000 for expansion, such as additional funds, the cost that is related to this 5 lakhs is marginal cost of capital. The weighted average cost of new or incremental, capital is known as the marginal cost of capital. The marginal cost of capital is the weighted average cost of new capital using the marginal weights. The marginal weights represent the proportion of various sources of funds to be employed in raising additional funds. The marginal cost of capital shall be equal to WACC, when a firm employs the existing proportion of capital structure and some cost of component of capital structure. But in practice WACC may not be equal to marginal cost of capital due to change in proportion and cost of various sources of funds used in raising new capital. The marginal cost of capital ignores the long-term implications of the new financing plans. Hence, WACC should be preferred, to maximise the shareholders wealth in the long-term. Illustration 24: HLL has provided the following information and requested you to calculate (a) WACC using book-value weights and (b) weighted marginal cost of capital (assuming that specified cost do not change). Source of Finance Amount ( ) Weights (%) After tax cost (%) Equity capital Preference capital Debentures 14,00,000 8,00,000 9,00, HLL wishes to raise an additional capital of details are as follows: Equity capital 3,00,000 Preference capital 3,00,000 Debentures 6,00,000 12,00,000 for the expansion of the project. The LOVELY PROFESSIONAL UNIVERSITY 111

118 Financial Management Solution: Computation of WACC Source of Finance Weights After tax Cost (%) Weighted Cost Equity capital Preference capital Debentures WACC = = 11.8 per cent Computation of Weighted Marginal Cost of Capital (WACC) Source of Finance Marginal Weights After tax Cost (%) Weighted marginal cost Equity capital Preference capital Debentures WACC = = 11.5 per cent Factors Affecting WACC Weighted average cost of capital is affected by a number of factors. They are divided into two categories such as: 1. Controllable Factors: Controllable factors are those factors that affect WACC, but the firm can control them. They are: (a) (b) (c) Capital Structure Policy: As we have assured, a firm has a given target capital structure where it assigns weights based on that target capital structure to calculate WACC. However, a firm can change its capital structure or proportions of components of capital that affect its WACC. For example, when a firm decides to use more debt and less equity, which will lead to reduction of WACC. At the same time increasing proportion of debt in capital structure increases the risk of both debt and equity holder, because it increases fixed financial commitment. Dividend Policy: The required capital may be raised by equity or debt or both. Equity capital can be raised by issue of new equity shares or through retained earnings. Sometimes companies may prefer to raise equity capital by retention of earnings, due to issue of new equity shares, which are expensive (they involve flotation costs). Firms may feel that retained earnings is less costly when compared to issue of new equity. But if it is different it is more costly, since the retained earnings is income that is not paid as dividends hence, investors expect more return and so it affects the cost of capital. Investment Policy: While estimating the initial cost of capital, generally we use the starting point as the required rate of return on the firm s existing stock and bonds. Therefore, we implicitly assume that new capital will be invested in assets of the same type and with the same degree of risk. But it is not correct as no firm invest in assets similar to the ones that currently operate, when a firm changes its investment policy. For example, investment in diversified business. 112 LOVELY PROFESSIONAL UNIVERSITY

119 Unit 6: Cost of Capital 2. Uncontrollable Factors: The factors that are not possible to be controlled by the firm and mostly affects the cost of capital. These factors are known as External factors. (a) (b) (c) Tax Rates: Tax rates are beyond the control of a firm. They have an important effect on the overall cost of the capital. Computation of debt involves consideration of tax. In addition, lowering capital gains tax rate relative to the rate on ordinary income makes stocks more attractive and reduces cost of equity and lower the overall cost of capital. Level of Interest Rates: Cost of debt is interest rate. If interest rates increases, automatically cost of debt also increases. On the other hand, if interest rates are low then the cost of debt is less. The reduced cost of debt decreases WACC and this will encourage an additional investment. Market Risk Premium: Market risk premium is determined by the risk in investing proposed stock and the investor s aversion to risk. Market risk is out of control risk, i.e., firms have no control on this factor. The above are the important factors that affect the cost of capital. Task Weighted average of cost of capital may be determined using book value and market value weights. Compare the pros and cons of using market value weights rather than book value weights in calculating WACC. Self Assessment Fill in the blanks: 13. The weighted average cost of new or incremental, capital is known as the Book value weights are based on the values found on the. 15. The..cost of capital lies between the least and most expensive funds. Case Study Case: Nike, Inc. Cost of Capital On July, Kimi-ford, a portfolio manager at North Point Group, a mutual-fundmanagement firm, pored over analysts write-ups of Nike, Inc., the athletic-shoe manufacturer. Nike s share price had declined significantly from the start of the year. Ford was considering buying some shares for the fund she managed, the North Point Large-Cap Fund, which invested mostly in fortune 500 companies, with an emphasis on value investing. Its top holdings included Exxon Mobile. General Motors, McDonald s, 3M, and other large-cap. It had performed extremely well. In 2000, the fund earned a return of 20.7 per cent even as the S&P 500 fell 10.1 per cent. The fund s year-to-date returns at the end of June 2001 stood at 6.4 versus the S&P 7.3 per cent. Only a week ago, on June 28,2001, Nike held an analyst meeting to disclose its fiscal-year 2001 results. The meeting, however had another purpose : Nike management wanted to communicate a strategy for revitalizing the company. Since 1997 Nike s revenues had plateaued at around $9 billion, while net income had fallen from almost $ 800 million to $580 million (see Exhibit 1). Nike s markets in the U.S. had fallen from 48 per cent in 1997 Contd... LOVELY PROFESSIONAL UNIVERSITY 113

120 Financial Management to 42 per cent in In addition, recent supply-chain issues and the adverse effect of a strong dollar had negatively affected revenue. At the meeting, the management revealed plans to address both-line growth and operating performance. To boost revenue, the company would develop more athletic-shoe products in the mid-priced segment a segment that had been overlooked in the recent years. Nike also planned to push its apparel line, which, under the recent leadership of industry veteran Mindy Grossman had performed extremely well. On the cost side, Nike would exert more effort on expense control, finally, the company s executives reiterated their long-term revenue growth targets of 8-10 per cent and earnings-growth targets of above 1 percent. The Analysts reactions were mixed. Some thought, the financial targets too aggressive ; other saw significant growth opportunities in apparel and in Nike s international businesses. Ford read all the analysts reports that she could find about the June 28 meeting, but the reports gave her no clear guidance: a Lehman Brothers report recommended a Strong Buy, while UBS analysts expressed misgiving about the company and recommended a Hold. Ford decided instead to develop her own discounted-cash-flow forecast to come to a clearer conclusion. Her forecast showed that, at discount rate of 12 per cent, Nike was overvalued at its current share price of $42.09 (see Exhibit 2). She had, however, done a quick sensitivity analysis that revealed Nike was valued at discount rates below 11.2 per cent. As she was about to go into a meeting, she asked her new assistant, Joanna Cohen, to estimate Nike s cost of capital. Cohen immediately gathered all the data she though she might need (Exhibits 1,2,3 and 4) began to work on her analysis. At the end of the day, she submitted her cost-of-capital estimate and a memo (Exhibit 5) explaining her assumption to Ford. Exhibit 1: Consolidated Income Statements Year ended May 31 (in millions excepts per share data) Revenues 4, , , , , , ,488.8 Cost of goods sold 2, , , , , , ,784.9 Gross profit 1, , , , , , ,703.9 Selling and administrative 1, , , , , , ,689.7 Operating Income , ,014.2 Interst expense Other expense net Restructuring charge,net Income before Income taxes , Income taxes Net Income Diluted earning per Annum Shares Average shares outstanding (diluted) Contd LOVELY PROFESSIONAL UNIVERSITY

121 Unit 6: Cost of Capital (diluted) Growth(%) Revenue Operating income Net income Margins (%) Gross margin Operating margin Net margin Effective tax rate (%) Exhibit 2: Discounted - Cash - flow Analysis Assumption Revenue growth (%) COGS/Sales (%) S & A / Sales (%) Tax rate (%) Current Assets / sales (%) Current liabilities/ sales (%) Yearly depreciations Equals capex. Cost of Capital (%) 12.0 Terminal growth rate (%) 3.0 Discounted cash flow Opeating income 1, , Taxes NOPAT Capex.net of dereciation Change in NWC Free cash flow Terminal value Total flows Present value of flows Enterprise value Less : current outstanding dept Equity value Current shares outstanding Equity value per share $37.27 Current share price $42.09 Contd... LOVELY PROFESSIONAL UNIVERSITY 115

122 Financial Management Exhibit 3: Sensitivity of Equity Value of Discount Rate Discount rate Equity value 8.00% $ Exhibit 4: Consolidated Balance Sheets (in millions) May Assets Current assets Cash and equivalents $254.3 $304.0 Accounts receivable 1, ,621.4 Inventories 1, ,424.0 Deferred income taxes Prepaid expenses Total Current assets 3, ,625.3 Property, plant and equipment, net 1, ,618.8 Identifiable, intangible assets and goodwill, net Deferred income taxes and other assets Total assets $5,856.9 $5,819.6 Liabilities and shareholder's equity Current Liabilities Current portion of long-term debt $50.1 $5.4 payable Accounts payable Accrued liabilities Income taxes payable Total current liabilities 2, ,786.7 Long-term debt Deferred income taxes and other liabilities Redeemable preferred stock Share holder equity Common stock, par Capital in excess of stated value Unearned stock comper Accumulated other comprehensive income Retained earnings Total share holder equity Total liabilities and shareholder's equity $5,856.9 $5,819.6 Contd LOVELY PROFESSIONAL UNIVERSITY

123 Unit 6: Cost of Capital Exhibit 5: Dr. Bhatt s Analysis Subject: Nike s Cost of Capital Based on the following assumptions, my estimate of Nike s cost of capital is 8.4 percent: Single or Multiple Costs of Capital The first question I considered was whether to use single or multiple costs of capital given that Nike has multiple business segments. Aside from footwear, which makes up 62 per cent of revenue. Nike also sells apparel (30 per cent of revenue) that complement its footwear products. In addition, Nike sells sport balls, time-pieces, eyewear, skates, bats and other equipment designed for sports activities. Equipment products account for 3.6 per cent of revenue. Finally, Nike also sells some non-nike branded products such as Cole-Haan dress and casual footwear, and ice stakes, skate blades, hockey sticks, hockey jerseys and other products under the Bauer trademark, non-nike brands account for 4.5 per cent of the revenue. I asked myself, whether Nike s different business segments shad enough risks from each other to warrant different costs of capital. Were their profiles really different? I concluded that it was only the Cole-Haan line that was somewhat different: the rest were all sportsrelated businesses. However, since Cole-Haan makes up only a tiny fraction of the revenues, I did not think it necessary to compute a separate cost of capital. As for the apparel and footwear lines, they are sold through the same marketing and distribution channels and are often marketed in collections of similar design. I believe, they face the same risk factors, as such, I decided to compute only one cost of capital of the whole company. Methodology for Calculating the Cost of Capital; WACC Since Nike is funded with both debt and equity, I used the Weighted Average Cost of Capital (WACC) method. Based on the latest available balance sheet, debt as a proportion of total capital makes up 27.0 per cent and equity accounts for 73.0 per cent: Capital sources Book Values Debt Current portion of long-term debt $ 5.4 payable Long-term debt Cost of Debt $ % of total capital $ % of total capital My estimate of Nike s cost of debt is 4.3 per cent. I arrived at this estimate by taking total interest expense for the year 2001 and dividing it by the company s average debt balance. The rare is lower than Treasury yields but that is because Nike raised a portion of its funding needs through Japanese yen notes, which carry rates between 2.0 per cent to 4.3 per cent. After adjusting for tax, the cost of debt comes to 2.7 per cent. I used a tax rate of 38 per cent, which I obtained by adding state taxes of 3 per cent to the U.S. statutory tax rate. Historically, Nike s state taxes have ranged from 2.5 per cent to 3.5 per cent. Contd... LOVELY PROFESSIONAL UNIVERSITY 117

124 Financial Management Cost of Equity I estimated the cost of equity, using the Capital Asset Pricing Model (CAPM). Other methods such as the Dividend Discount Model (DDM) and the Earnings Capitalization Ratio can be used to estimate the cost of equity. However, in my opinion, the CAPM is the superior method. My estimate of Nike s cost of equity is 10.5 per cent I used the current yield on 20-year Treasury bonds as my risk-free rate, and the compound average premium of the market over Treasury bonds (5.9 per cent) as my risk premium. For beta, I took the average of Nike s beta from 1996 to the present. Putting it all Together After inputting all my assumptions into the WACC formula, my estimate of Nike s cost of capital is 8.4 per cent. Question WACC = Kd (1 t) D/(D + E) + Kc E/(D + E) = 2.7% 27.0% % 73.0% = 8.4% What is the importance of cost of capital for any firm? 6.6 Summary The cost of capital is viewed as one of the corner stones in the theory of financial management. Cost of capital may be viewed in different ways. Cost of capital is the weight average cost of various sources of finance used by the firm. It comprises the risk less cost of the particular type of financing (r j ), the business risk premium, (b) and the financial risk premium (f). The cost of capital is useful in designing optimal capital structure, investment evaluation, and financial performance appraisal. The financial manager has to compute the specific cost of each type of funds needed in the capitalisation of a company. Retained earnings are one of the internal sources to raise equity finance. The opportunity cost of retained earning is the rate of return the shareholder forgoes by not putting his funds elsewhere. Cost of equity capital, is the minimum rate of return that a firm must earn on the equity financed portions of an investment project in order to leave unchanged the market price of the shares. The marginal cost of capital is the weighted average cost of new capital using the marginal weights. Marginal cost of capital shall be equal to WACC, when a firm employs the existing proportion of capital structure and some cost of component of capital structure. 118 LOVELY PROFESSIONAL UNIVERSITY

125 Unit 6: Cost of Capital 6.7 Keywords Cost of Capital: It is that minimum rate of return, which a firm must earn on its investments so as to maintain the market value of its shares. Explicit Cost: It is the discount rate that equates the present value of the cash inflows with the present value of its increments cash outflows. Future Cost: It is the cost of capital that is expected to raise the funds to finance a capital budget or investment proposal. Implicit Cost: It is the cost of opportunity which is given up in order to pursue a particular action. Marginal Cost of Capital: The additional cost incurred to obtain additional funds required by a firm. Opportunity Cost: The benefit that the shareholder foregoes by not putting his/her funds elsewhere because they have been retained by the management. Specific Cost: It is the cost associated with particular component or source of capital. Spot Cost: The cost that are prevailing in the market at a certain time. 6.8 Review Questions 1. Examine the relevance of cost of capital in capital budgeting decisions. 2. Elucidate the importance of CAPM approach for calculation of cost of equity. 3. Marginal cost of capital nothing but the average cost of capital. Explain. 4. Analyse the concept of flotation costs in the determination of cost of capital. 5. AMC Engineering Company issues 12 per cent, 100 face value of preference stock, which is repayable with 10 per cent premium at the end of 5 years. It involves a flotation cost of 5 per cent per share. What is the cost of preference share capital, with 5 per cent dividend tax? 6. Evaluating the capital budgeting proposals without cost of capital is not possible. Comment. 7. VS International is thinking of rising funds by the issuance of equity capital. The current market price of the firm s share is 150. The firm is expected to pay a dividend of 3.9 next year. At present, the firm can sell its share for 140 each and it involves a flotation cost of 10. Calculate cost of new issue. 8. WACC may be determined using the book values & the market value weights. Compare the pros & cons of using market value weights rather than book value weights in calculating the WACC. 9. Critically evaluate the different approaches to the calculation of cost of equity capital. 10. A company issues 12,000, 12 per cent perpetual preference shares of 100 each. Company is expected to pay 2 per cent as flotation cost. Calculate the cost of preference shares assuming to be issued at (a) face value of par value, (b) at a discount of 5% and (c) at a premium of 10%. 11. An investor supplied you the following information and requested you to calculate. Expected rate of returns on market portfolio Risk free returns = 10 per cent LOVELY PROFESSIONAL UNIVERSITY 119

126 Financial Management Investment in Company Initial Price Dividends Year-end Market Price A Paper Steel Chemical B GOI Bonds Beta risk Factor 12. A company currently is maintaining 6 per cent rate of growth in dividends. The last year dividend was 4.5 per share. Equity share holders required rate of return is 15 per cent. What is the equilibrium price per share? 13. Karvy is planning to sell equity shares. Mr. Ram wishes to invest in Karvy Company by purchasing equity shares. The company s bond has been yielding at 13 per cent. You are requested by Mr. Ram to calculate his expected rate of return on equity based on bond yield plus risk premium approach (assuming 3 per cent as risk premium). 14. Sai Enterprises issued 9 per cent preference share (irredeemable) four years ago. The preference share that has a face value of 100 is currently selling for 93. What is the cost of preference share with 8 per cent tax on dividend? 15. Company has 50,000 preference shares of 100 at par outstanding at 11 per cent dividend. The current market price of the share is 90. What is its cost? Answers: Self Assessment 1. rate of return 2. percentage. 3. capital formation 4. debt 5. Cost of Capital 6. actual profitability 7. marginal 8. Future Cost 9. Spot 10. interest rate 11. discount rate 12. opportunity 13. marginal cost of capital 14. balance sheet 15. composite 6.9 Further Readings Books Dr Pradeep Kumar Sinha, Financial Management, New Delhi, Excel Books, Sudhindra Bhat, Financial Management, New Delhi, Excel Books, Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of Financial Management, New Delhi, Prentice Hall of India Pvt. Ltd., 1996, p. 2. Chandra, P., Financial Management Theory and Practice, New Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p LOVELY PROFESSIONAL UNIVERSITY

127 Unit 7: Capital Structure Decision Unit 7: Capital Structure Decision CONTENTS Objectives Introduction 7.1 Meaning of Capital Structure 7.2 Major Considerations in Capital Structure Planning 7.3 Value of the Firm and Capital Structure 7.4 Capital Structure Theories Net Income (NI) Approach Net Operating Income (NOI) Approach Modigliani Miller s Approach (Extension of NOI Approach) 7.5 Effects of a Financing Decision on Earnings Per Share 7.6 Summary 7.7 Keywords 7.8 Review Questions 7.9 Further Readings Objectives After studying this unit, you will be able to: Define the capital structure Recognize the conception of optimum capital structure Explain the different considerations in capital structure planning Describe the theories of capital structure. Introduction Organizations have need of funds to run and maintain its business. The requisite funds may be raised from short-term sources or long-term sources or a combination both the sources of funds, so as to equip itself with an appropriate combination of fixed assets and current assets. Current assets to a considerable extent, are financed with the help of short-term sources. Normally, firms are expected to follow a prudent financial policy, as revealed in the maintenance of net current assets. This net positive current asset must be financed by long-term sources. Hence, long-term sources of funds are required to finance for both (a) long-term assets (fixed assets) and (b) networking capital (positive current assets). The long-term financial strength as well as profitability of a firm is influenced by its financial structure. The term Financial Structure refers to the left hand side of the balance sheet as represented by total liabilities consisting of current liabilities, long-term debt, preference share and equity share capital. The financial structure, therefore, includes both short-term and long-term sources of funds. LOVELY PROFESSIONAL UNIVERSITY 121

128 Financial Management 7.1 Meaning of Capital Structure The basic objective of financial management is to maximize the shareholders wealth. Therefore, all financial decisions in any firm should be taken in the light of this objective. Whenever a company is required to raise long-term funds the finance manager is required to select such a mix of sources of finance that overall cost of capital is minimum (i.e., value of the firm/wealth of shareholders is maximum). Mix of long-term sources of finance is referred as capital structure. Optimum Capital Structure The capital structure is said to be optimum when the firm has selected such a combination of equity and debt so that the wealth of firm (shareholder) is maximum. At this capital structure, the cost of capital is minimum and market price per share is maximum. It is very difficult to find out optimum debt and equity mix where capital structure would be optimum because it is difficult to measure a fall in the market value of an equity shares on account of Increase in risk due to high debt content in capital structure. Hence, in practice, the expression appropriate capital structure is more realistic expression than optimum capital structure. Features of an Appropriate Capital Structure 1. Profitability: The most profitable capital structure is one that tends to minimize cost of financing and maximize earning per equity share. 2. Flexibility: The capital structure should be such that company can raise funds whenever needed. 3. Conservation: The debt content in the capital structure should not exceed the limit, which the company can bear. 4. Solvency: The capital structure should be such that firm does not run the risk of becoming insolvent. 5. Control: The capital structure should be so devised that it involves minimum risk of loss of control of the company. Self Assessment Fill in the blanks: 1. Capital structure is referred as mix of..sources of finance. 2. At.capital structure, the cost of capital is minimum and market price per share is maximum. 3. The most profitable capital structure is one that tends to minimize.and maximize earning per equity share. 7.2 Major Considerations in Capital Structure Planning ln planning the capital structure, one should keep in mind that there is no one definite model that can be suggested/used as an ideal for all business undertakings. This is because of varying circumstances of business undertakings. It is, therefore important to understand that different types of capital structure would be required for different types of business undertakings. 122 LOVELY PROFESSIONAL UNIVERSITY

129 Unit 7: Capital Structure Decision The capital structure depends primarily on number of factors like: The nature of industry, Gestation period, Certainty with which the profit will accrue after the undertaking goes into commercial production, and The likely quantum of return on investment. However, finance manager should take into consideration following factors while planning the capital structure: 1. Risk: Risk is of two kinds, i.e. financial risk and business risk. In the context of capital structure planning, financial risk is relevant. Financial risk also is of two types: (a) (b) Risk of cash insolvency: As a firm raises more debt, its risk of cash insolvency increases. This is due to two reasons. Firstly, higher proportion of debt in the capital structure increases the commitments of the company with regard to fixed charges. This means that a company stands committed to pay a higher amount of interest irrespective of the fact whether it has cash or not. Secondly, the possibility that the supplier of funds may withdraw the funds at any given point of time. Thus, the long-term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. This risk is not there in the case of equity shares. Risk of variation in the expected earnings available to equity shareholders: In case a firm has higher debt content in capital structure, the risk of variations in expected earnings available to equity shareholders will be higher. This is because of trading on equity, Financial leverage works both ways, i.e.; it enhances the shareholders return by a high magnitude, or brings it down sharply depending upon whether the return on investment is higher or lower than the rate of interest. 2. Cost of capital: Cost is an important consideration in capital structure decisions, it is obvious that a business should be at least capable of earning enough revenue to meet its cost of capital and finance its growth. 3. Control: Along with cost and risk factors, the control aspect is also important consideration in planning the capital structure. When a company issues further equity shares, it automatically dilutes the controlling interest of the present owners. Similarly, preference shareholders can have voting rights and thereby affect the composition of the Board of Directors in case dividends on such shares are not paid for two consecutive years. Financial institutions normally stipulate that they shall have one or more directors on the Board. Hence, when the management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its control over the company. It is obvious therefore, that decisions concerning capital structure are taken after keeping the control factor mind. 4. Trading on Equity: A company may raise funds either by the issue of shares or by borrowings. Borrowings carry a fixed rate of interest and this interest is payable irrespective of fact whether there is profit or not. Of course, preference shareholders are also entitled to a fixed rate of dividend but payment of dividend is subject to the profitability of the company. In case the Rate Of Return (ROI) on the total capital employed i.e. shareholders funds plus log term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, it is said that the company is trading on equity. One of the prime objectives of a finance manager is to maximize both the return on ordinary LOVELY PROFESSIONAL UNIVERSITY 123

130 Financial Management shares and the tota1 wealth of company. This objective has to be kept in view while making a decision on a new source of finance its impact on the earnings per share has to be carefully analyzed. This helps in deciding whether funds should be raised by internal equity or by borrowings. 5. Corporate Taxation: Under the Income Tax laws, dividend on shares is not deductible, while interest paid on borrowed capital is allowed as deduction for computing taxable income. The cost of raising finance through borrowing is deductible in the year in which it is incurred. If it is incurred during the pre-commencement period, it is to be capitalized. Cost of issue of shares is allowed as deduction. Owing to these provisions corporate taxation plays an important role in determining the choice between different sources of financing. 6. Government Policies: Government policies are a major factor in determining capital structure. Example: a change in the lending policies of financial institutions may mean a complete change in the financial pattern to be followed in the companies. Similarly, the Rules and Regulations framed by SEBI considerably affect the capital issue policy of various companies. Monetary and fiscal policies of the government also affect the capital structure decisions. 7. Legal Requirements: The finance manager has to keep in view the legal requirements while deciding about the capital structure of the company. 8. Marketability: To obtain a balanced capital structure it is necessary to consider the ability of the company to market corporate securities. 9. Maneuverability: Maneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement of funds. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing with the prospective suppliers of funds. 10. Flexibility: Flexibility refers to the capacity of the business and its management to adjust to expect and unexpected changes in circumstances. In other words, management would like to have a capital structure, which provides maximum freedom to changes at all times. 11. Timing: Closely related to flexibility is the timing for issue of securities. Proper timing of a security issue often brings substantial savings because of the dynamic nature of the capital market. An Intelligent management tries to anticipate the climate in capital market with a view to minimize the cost of raising funds and also to minimize the dilution resulting from an issue of new ordinary shares. 12. Size of the Company: Small companies rely heavily on owners funds while large companies are generally considered to be less risky by the investors and therefore, they can issue different types of securities. 13. Purpose of Financing: The purpose of financing also to some extent affects the capital structure of the company. In case funds are required for productive purposes like manufacturing etc.; the company may raise funds through long-term sources. On other hand, if funds are required for non-productive purposes, like welfare facilities to employees such as schools, hospitals etc., the company may rely only on internal resources. 14. Period of Finance: The period for which finance is required also effects the determination of capital structure. In case such funds are required for long-term requirements, say LOVELY PROFESSIONAL UNIVERSITY

131 Unit 7: Capital Structure Decision years, then it will be appropriate to raise borrowed funds. However, if the funds are required more or less permanently, it will be appropriate to raise them by the issue of equity share. 15. Nature of Enterprise: The nature of enterprise too, to a great extent, affects the capital structure or the company. Business enterprises that have stability in their earnings or those who monopoly regarding their products may go for borrowings or preference shares, since they have adequate profits to pay interest/fixed charges. On the contrary, companies, which do not have assured income, should preferably rely on internal resources to a large extent. 16. Requirement of Investors: Different types of securities are issued to different classes of investors according to their requirement. 17. Provision for Future: While planning capital structure the provision for future requirement of capital is also to be considered.! Caution Along with the risk as a factor, the finance manager has to consider the cost aspect carefully while determining the capital structure. Self Assessment Fill in the blanks: 4. In the context of capital structure planning,..risk is relevant. 5. Along with cost and risk factors, the..aspect is also important consideration in planning the capital structure. 6. In case a firm has higher debt content in capital structure, the risk of variations in.available to equity shareholders will be higher. 7.3 Value of the Firm and Capital Structure Value of the firm depends on the earnings of the firm and earnings of the firm depend upon the investment decisions of the firm. Investment decision influences the size of the EBIT. The EBIT is shared among three main claimants: 1. The debt holders who receive their share in the form of interest. 2. The government which receives its share in the form of taxes. 3. The shareholders who receive the balance. Thus, the investment decisions of the firm determine the size of the EBIT pool while the capital structure mix determines the way it is to be sliced. The total value of the firm is the sum of the value to the debt holders and its shareholders. Therefore, investment decision can increase the value of the firm by increasing the size of the EBIT whereas capital structure mix can affect the value only by reducing the share of the EBIT going to the government in the form of taxes. Thus, the value of the firm, investment decisions and capital structure decisions are closely related and is depicted by the following figure. LOVELY PROFESSIONAL UNIVERSITY 125

132 Financial Management Figure 7.1: Relation between Value of Firm, Investment Decision and Capital Structure Decisions Did u know? What are the Patterns/Forms of Capital Structure? The following are the forms of capital structure. 1. Complete equity share capital; 2. Different proportions of equity and preference share capital; 3. Different proportions of equity and debenture (debt) capital; and 4. Different proportions of equity, preference and debenture (debt) capital. Self Assessment Fill in the blanks: 7. Investment decisions of the firm determine the size of the.pool 8. The EBIT is shared among three main claimants which are debt holders, government and.who receive the balance. 9. The total value of the firm is the sum of the value to the.and its shareholders. 7.4 Capital Structure Theories These approaches analyze the relationship between the leverage, the cost of capital and the value of the firm in different ways. However, the following assumptions are made to understand these relationships. 1. There are only two sources of funds viz., debt and equity. 2. The total assets of firm are given. The degree of leverage can be changed by selling debt to repurchase shares or selling shares to retire debt. 3. There are no retained earnings. It implies that entire profits are distributed among shareholders. 4. The operating profit of firm is given and expected to grow. 126 LOVELY PROFESSIONAL UNIVERSITY

133 Unit 7: Capital Structure Decision 5. The business risk is assumed to be constant and is not affected by the financing mix decision. 6. There are no corporate or personal taxes. 7. The investors have the same subjective probability distribution of expected earnings Net Income (NI) Approach The Net Income (NI) approach is the relationship between leverage and cost of capital and value of the firm. This theory states that there is a relationship between capital structure and the value of the firm and therefore, the firm can affect its value by increasing or decreasing the debt proportion in the overall financing mix. The NI approach makes the following additional assumptions: 1. That the total capital requirement of the firm is given and remains constant. 2. That cost of debt is less than cost of equity capitalization rate. 3. There are no corporate taxes. 4. The use of debt content does not change the risk reception of the investors as a result; both the debt capitalization rate and the equity capitalization rate remain constant. Did u know? Who suggested NI Approach? NI (Net Income) Approach is suggested by Durand. The NI approach starts from the argument that change in financing mix of a firm will lead to change in Weighted Average Cost of Capital (WACC) of the firm, resulting in the change in value of the firm. As debt capitalization is less than equity, the increasing use of cheaper debt (and simultaneous decrease in equity proportion) in the overall capital structure will result in magnified returns to the shareholders. The increased returns to the shareholders will increase the total value of the equity and this increases the total value of the firm. The WACC will decrease and the value of the firm will increase. On the other hand, if the financial leverage is reduced by the decrease in the debt financing, the WACC of the firm will increase and the total value of the firm will decrease. The NI approach to the relationship between leverage costs of capital has been presented graphically. Figure 7.2: NI Approach The value of the firm on the basis of Net income approach can be ascertained as follows: V= S+D. Where V = Value of the firm S = Market value of equity. D = Market value of debt. LOVELY PROFESSIONAL UNIVERSITY 127

134 Financial Management Market value of equity (S) = NI Ke Where, NI = Earnings available for equity shareholders, Ke = Equity capitalization rate. Under NI approach, the value of the firm will be maximum at a point where average cost of capital is minimum. Thus the theory suggests total or maximum possible debt financing for minimizing the cost of capital. The overall cost of capital = E.B.I.T. Value of the firm 100 The NI approach can be illustrated with the help of the following example. Example: Expected EBIT of the firm is 2,00,000. The cost of equity (i.e., capitalization rate) is 10%. Find out the value of Firm and overall cost of capital if degree of leverage is: Debenture interest rate is 6%. Statement Showing the Value of Firm and Overall Cost of Capital WACC Conclusion: Firm is able to increase its value and to decrease it s (WACC) increasing the debt proportion in the capital structure. The NI approach, though easy to understand, ignores perhaps the most important aspects of leverage that the market price depends upon the risk, which varies in direct relation to the changing proportion of debt in capital structure Net Operating Income (NOI) Approach The Net Operating Income (NOI) approach is the opposite of the NI approach. According to the NOI approach, the market value of the firm depends upon the net operating profit or EBIT and 128 LOVELY PROFESSIONAL UNIVERSITY

135 Unit 7: Capital Structure Decision the overall cost of capital, WACC. The financing mix or the capital structure is irrelevant and does not affect the value of the firm. The NOI approach makes the following assumptions: 1. Investors see the firm as a whole and thus capitalize the total earnings of the firm to find the value of the firm as a whole. 2. The overall cost of capital of the firm is constant and depends upon the business risk, which also is assumed to be unchanged. 3. The cost of debt is also taken as constant. 4. The use of more and more debt in the capital structure increases the risk of shareholders and thus results in the increase in the cost of equity capital i.e., the increase in cost of equity is such, as to completely offset the benefits of employing cheaper debt, and 5. There is no tax. The NOI approach is based on the argument that the market values the firm as a whole for a given risk complexion. Thus, for a given value of EBIT, the value of the firm remains the same, irrespective of the capital composition and instead depends on the overall cost of capital. The value of the equity may be found by deducting the value of debt from the total value of the firm i.e., V = EBIT Ko E = Value of equity V = Value of firm. D = Market value of debt And E = V D And the cost of equity capital, Ke, is Ke = EBIT - Interest V - D Thus, the financing mix is irrelevant and does not affect the value of the firm. The value remains same for all types of debt-equity mix. Since there will be change in risk of the shareholders as a result of change in debt-equity mix, therefore, the Ke will be changing linearly with change in debt proportions. The NOI approach to the relationship between the leverage and cost of capital has been presented in the following figure. Figure 7.3: NOI Approach The above diagram shows that the cost of debt, Kd, and the overall cost of capital Ko are constant for all levels of leverage. As the debt proportion or the financial leverage increases, the risk of LOVELY PROFESSIONAL UNIVERSITY 129

136 Financial Management the shareholders remains constant because increase in Ke is just sufficient to off set the benefits of cheaper debt financing. The NOI approach considers Ko to be constant and therefore, there is no optimal capital structure as good as any other and so every capital structure is an optimal one. The NOI approach can be illustrated with an example. Example: A firm has an EBIT of 200,000 and belongs to a risk class of 10%. What is the value of cost of equity capital, if it employs 6% debt to the extent of 30%, 40% or 50% of the total capital fund of 10,00,000? Solution: The effect of changing debt proportion on the cost of equity capital can be analyzed as follows: The NI and the NOI approach hold extreme views on the relationship between the leverage, cost of capital and the value of the firm. In practical situations, both these approaches seem to be unrealistic. The traditional approach takes a compromising view between the two and incorporates the basic philosophy of both. It takes a midway between the NI approach (that the value of the firm can be increased by increasing the leverage) and the NOI approach (that the value of the firm is constant irrespective of the degree of financial leverage). The traditional viewpoint states that the value of the firm increases with increase in financial leverage but only up to a certain limit. Beyond this limit, the increase in financial leverage will increase its WACC and hence the value of the firm will decline. Under the traditional approach, the cost of debt is assumed to be less than the cost of equity. In case of 100% equity firm, overall cost of the firm is equal to the cost of equity, but, when (cheaper) debt is introduced in the capital structure and the financial leverage increases, the cost of equity remains the same as the equity investors expect a minimum leverage in every firm. The cost of equity does not increase even with increase in leverage. The argument for Ke remaining unchanged may be that up to a particular degree of leverage, the interest charge may not be large enough to pose a real threat to the dividend payable to the shareholders. This constant Ke and Kd makes the Ko to fall initially. Thus, it shows that the benefits of cheaper debts are available to the firm. But this position does not continue when leverage is further increased. The increase in leverage beyond a limit increases the risk of the equity investors too and as a result the Ke also starts increasing. However, the benefits of use of debt may be so large that even after offsetting the effects of increase in Ke, the Ko may still go down or may become constant for some degree of leverages. However, if the firm increases leverage further, then the risk of the debt investor may also increase and consequently the Kd of debt also starts increasing. The already increasing Ke and 130 LOVELY PROFESSIONAL UNIVERSITY

137 Unit 7: Capital Structure Decision the now increasing makes the Ko increase. Therefore, the use of leverage beyond a point will have the effect of increase the overall cost of capital of the firm and thus results in the decrease in the value of the firm. Thus, there is a level of financial leverage in any firm, up to which it favorably affect the value of the firm may decrease. There may be a particular leverage or a range of leverage, which separates the favorable leverage. The traditional viewpoint has been shown in the following figure. Figure 7.4 As per traditional approach, a firm can be benefited from a moderate level of leverage when the advantage of using debt (having lower cost) outweigh the disadvantages of increasing Ke (as a result of higher financial risk). The overall cost of capital Ko, therefore, is a function of a financial leverage. The value of the firm can be affected therefore, by the judicious use of debt and equity to capital structure. Example: ABC Ltd., having an EBIT of 1,50,000 is contemplating to redeem a part of the capital by introducing debt financing. Presently, it is a 100% equity firm with equity capitalization rate, Ke, of 16%. The firm is to redeem the capital by introducing debt financing up to 3,00,000 i.e., 30% of total funds or up to 5,00,000 i.e., 50% of the total funds. It is expected that for the debt financing up to 30%, the rate of interest will be 10% and the equity capitalization will increase up to 17%. However, if the firm opts for 50% debt financing, then interest will be payable at the rate of 12% and the equity capitalization rate will be 20%. Find out the value of the firm and its overall cost of capital under different levels of debt financing. Solution: On the basis of the information given, the total funds of the firm is 10,00,000 (whole of which is provided by the equity capital) out of which 30% or 50% i.e., 3,00,000 or 5,00,000 may be replaced by the issue of debt bearing interest at 10% or 12% respectively. The value of the firm and its WACC maybe ascertained as follows: Contd... LOVELY PROFESSIONAL UNIVERSITY 131

138 Financial Management The example shows that with the increase in leverage from 0% to 30%, the firm is able to reduce its WACC from 16% to 14.9% and the value of the firm increases from 9,37,500 to 10,05,882. This happens as the benefits of employing cheaper debt are available and the cost of equity does not rise too much. However, thereafter, when the leverage is increased further to 50%, the cost of debt as well as the cost of equity, both, rises to 12% and 20% respectively. The equity investors have increased the equity capitalization rate to 20% as they are now finding the firm to be more risky (as a result of 50% leverage). The increase in cost of debt and the equity capitalization rate has increased the cost of equity, hence as a result, the value of the firm has reduced from 10,05,882 to 9,50,000 and Ko has increased from 14.9% to 15.8% Modigliani Miller s Approach (Extension of NOI Approach) The Modigliani Millers (MM) model is considered to be one of the most influential papers ever written in corporate finance. The Modigliani Miller approach is similar to the Net Operating Income (NOI) approach. In other words, according to this approach, the value of a firm is independent of its capital structure. However, there is a basic difference between the two. The NOI approach is purely conceptual. It does not provide operational justification for irrelevance of the capital structure in the valuation of the firm. While MM approach supports the NOI approach providing behavioural justification for the independence of the total valuation and the cost of capital of the firm from its capital structure. In other words, MM approach maintains that the weighed average cost of capital does not change in the debt equity mix or capital structure of the firm. Did u know? When was Modigilani Miller (MM) represented? Modigilani Miller (MM) was represented in 1958 Basic Proportions The following are the three basic proportions of the MM approach. 1. The overall cost of capital (K) and the value of the firm (V) are independent of the capital structure. In other words, K and V are constant for all levels of debt-equity mix. The total market value of the firm is given by capitalizing the expected Net Operating Income (NOI) by the rate appropriate for that risk class. 2. The cost of equity (Ke) is equal to capitalization rate of a pure equity stream plus a premium for the financial risk. The financial risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to off set exactly the use of a less expensive source of funds represented by debt. 3. The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. 132 LOVELY PROFESSIONAL UNIVERSITY

139 Unit 7: Capital Structure Decision Assumptions The MM approach is subject to the following assumptions: 1. Capital markets are perfect: This means that investors are free to buy and sell securities. 2. The form can be classified into homogenous risk classes. All the forms within the same class will have the same degree of business risks. 3. All investors have the same expectations of a firm s net operating income (EBIT) with which to evaluate the value of any firm. 4. The dividend payout ratio is 100%. In other words, there are no retained earnings. 5. There are no corporate taxes. However, this assumption has been removed later. In brief, the MM hypothesis can be put in the following words: MM hypothesis is based on the idea that no matter how you bifurcate the capital structure of a firm among debt, equity and other claims, there is a conservation of investment value. That is because the total investment value of a corporation depends upon its underlying profitability and risk. It is invariant with respect to relative changes in the firm s financial capitalization. Thus, the total pie does not change as it is divided into debt, equity and other securities. The sum of the parts must equal the whole; so regardless of financing mix; the total value of the firm stays the same. Arbitrage Process The arbitrage process is the operational justification of MM hypothesis. The term arbitrage refers to an act of buying a security in one market having lower price and selling it in another market at higher price. As a result of such action, the market prices of the securities can not remain different markets. Thus, arbitrage process restores equilibrium in the value of securities. This is because investors of the overvalued firm would sell their shares, borrow additional funds on personal account and invest in the undervalued firm in order to obtain the same return on smaller investment outlay. The use of debt by the investor for arbitrage is termed as home made leverage or personal leverage. Arbitrage process can be explained with the help of the following example. Example: Two firms X Ltd. & Y Ltd. are alike and identical in all respects except that X Ltd. is a levered firm and has 10% debt of 30,00,000 in its capital structure. On the other hand Y Ltd. is an unlevered firm and has raised funds only by way of equity capital. Both these firms have same EBIT of 10,00,000 and equity capitalization rate (Ke) of 20%. Under these parameters, the total value and the WACC of both the firms may be ascertained as follows: LOVELY PROFESSIONAL UNIVERSITY 133

140 Financial Management Comments Though, EBIT is same, value of both the firm and WACC are different. MM argue that this position can not persist for a long; and soon there will be equilibrium in the values of the two firms through arbitrage process, which is explained, in the following paragraphs. Mr. A is holding 10% equity shares in X Ltd. The value of his loading is 3,50,000 i.e., 10% of 35,00,000. Further, he is entitled for 70,000 income (i.e., 10% of total profits of 7,00,000). In order to earn more income, he disposes off his holding in X Ltd. for 3,50,000 and buys 10% holding in Y Ltd. For this purpose, he adopts following steps. Step 1: In order to buy 10% holding in Y Ltd, he requires total funds of 5,00,000, whereas his proceeds are only 3,50,000. Therefore, he borrows 3,00,000 10% i.e. (10% of Debt of X Ltd). Thus, he substitutes personal loan for corporate loan. Step 2: Step 3: Mr. A now has total funds of 6,50,000 Sale proceeds 3,50,000 10% personal loan 3,00,000 Total 6,50,000 Less: Invest in shares of Y Ltd shares 5,00,000 Surplus funds (which he invests 1,50,000 in some other securities say at 10%) Mr. A will earn more through arbitrage process. Profits available to A from Y Ltd. (10% of 10,00,000) 1,00,000 Less: interest on borrowing (10% 300,00,000) 30,000 + Interest income on some other investment ( %) + 15,000 Total income after Arbitrage Process 85,000 Conclusion MM model argues that this opportunity to earn extra income through arbitrage process will attract so many investors. The gradual increase in sales of shares of the levered firm X Ltd. will push down its prices and the tendency to purchase the shares to unlevered firm Y Ltd. will drive its prices up. These selling and purchasing processes will continue until the market value of the two firms is equal. At this stage, the value of the leverage and unleveled firm and also their cost of capital are same. Thus overall cost of capital is independent of the financial leverage. Criticism Theoretically speaking, the MM model seems to be good. However, most of its assumptions are unrealistic and untenable. Following are criticisms against MM Model: 1. The arbitrage process, which provides the behavioural justification for the model is itself questionable in real life because of following reasons: (a) Investors do not have complete information about levered and unlevered firms. 134 LOVELY PROFESSIONAL UNIVERSITY

141 Unit 7: Capital Structure Decision (b) It is extremely doubtful that investors would substitute personal leverage for corporate leverage, as they do not have the same risk characteristics. Rates of interests are not the same for individuals and the firms. 2. The assumption that there is no corporate tax is unrealistic.! Caution Existence of corporate tax results in higher value of the levered firm, since the interest is tax deductible. 3. The assumption of no tries transaction cost is also imaginary. In reality, whenever a firm tries to obtain debt capital associates creditors, they seek certain restrictions on the firm. On the part of the firm, some protective comments incorporated in the loan contract. 4. In subsequently analyses, MM agreed that the leverage might increase the value of the firm. Task As the debt-equity ratio increases, there is a trade-off between the interest tax shield and bankruptcy, causing an optimum capital structure. Do you agree with the statement? Give reasons. Self Assessment Fill in the blanks: 10. The Net Income (NI) approach is the relationship between leverage and and value of the firm. 11. The.. is the operational justification of MM hypothesis. 12. The Net Operating Income (NOI) approach is the opposite of the.approach. 7.5 Effects of a Financing Decision on Earnings Per Share One of the present objectives of a finance function is to maximize both the return on ordinary shares and the total wealth of the company. This objective is also important at the time of deciding in the new source of finance. Earnings Per Share (EPS) denote what has been earned by the company during a particular period in each of the ordinary shares. It can be worked out by dividing net profit after interest, taxes and preference dividend, by the number of equity shares. If the company has a number of options of new financing, it can compute the impact of each method of new financing on earnings per share. It should also calculate the EPS without the new financing and compares it with cash of the various alternatives of financing available, is accepted. It is obvious that earnings per share would be the highest in case of financing, which has the least cost to the company. Example: X Ltd. requires 50 lacs for a new plant, which is expected to yield earnings before interest and taxes of 10 lacs. The company has three alternatives for financing. Option I: Raising debt of Option II: Raising debt of Option III: Raising debt of 5 lacs and the balance by equity. 20 lacs and the balance by equity. 30 lacs and the balance by equity. LOVELY PROFESSIONAL UNIVERSITY 135

142 Financial Management The company s share is currently selling at 150, but it expected to decline to 125 in case the funds are borrowed in excess of 20 lacs. The funds can be borrowed at the rate of 10% up to 50 lacs at 15% over 5 lacs and up to 20 lacs and at 20% over 20 lacs. The tax rate applicable to the company is 50%. Which option of financing the company should choose? Solution: The earnings per share is higher in Alternative 2 i.e., if the company finances the project by raising debt of 70,00,000 and issue equity shares of 30,00,000. Task The existing capital structure of XYZ Ltd. is as under: The existing rate of return on the company s capital is 12% and I/T rate 50%. The company requires a sum of 25,00,000 to finance its expansion programme for which it is considering the following alternatives: (a) Issue of 20,000 equity shares at a premium of 25 per share. (b) (c) Issue of 10% preference shares. Issue of 8% debentures. It is estimated that the P/E ratio in case of equity, preference and debentures financing would be 20, 17 and 16 respectively. Which of these alternatives would you advocate? Why? EPS Volatility EPS Volatility refers to the magnitude or the extent of fluctuations of earnings per share of a company in various years as compared to the mean or average earnings per share. In other words, EPS volatility shows whether a company enjoys a stable income or not. Did u know? Higher the EPS volatility, greater would be the risk attached to the company. A major cause of EPS volatility would be the fluctuations in the sales volume and the operating leverage. It is obvious that the net profits of a company would greatly fluctuate with small 136 LOVELY PROFESSIONAL UNIVERSITY